184 International Organization This is not to say that MNEs in more democratic countries do not have access to host governments,but MNEs'influence is likely to be balanced and diluted by various opposing groups in these countries.Conversely,where democratic institu- tions are weak and autocratic characteristics are strong,the host government is exposed to pressures of only limited social interests and,as Evans suggests,may resolve the dilemma by forming an alliance of the state,local,and multinational capital.38 Restrictions on political participation further prevent the losing groups from getting organized and affecting the policymaking process. Effect on fiscal and financial incentives to foreign capital.Democratic insti- tutions also limit the generosity of the fiscal and financial incentives host coun- tries often offer to attract foreign investors,placing more-democratic LDCs at a comparative disadvantage in the hunt for FDI.Inducements are one of many fac- tors affecting the choice of FDI location.39 Examples of such inducements include tax holidays,exemptions from import duties,deductions from social security con- tributions,accelerated depreciation allowances,investment grants,subsidized loans, donations of land or site facilities,and wage subsidies.During the past two de- cades,various developing countries,regardless of their regime type,have used these fiscal and financial incentives to lure foreign capital in an increasingly vig- orous competition.Even Cuban leader Fidel Castro has joined the bandwagon, remarking,"Who would have thought that we,so doctrinaire,we who fought for- eign investment,would one day view foreign investment as an urgent need?"40 Democratic politics matters for the design of various incentive programs.Any inducement to foreign capital,such as tax breaks or subsidies,represents a trans- fer of benefits from domestic taxpayers or firms to foreign investors.As noted earlier,where democratic institutions are strong,domestic players have various ways to pressure elected executives and legislators and influence policymaking. Hence,the host government is limited in its degree of freedom to supply or up- grade such incentives.Compared with more autocratic countries,more democratic host governments have a harder time obtaining the acquiescence of opposing do- mestic interests to the provision of generous incentives to foreign capital. Conditions particular to the LDCs also suggest that opposition by domestic in- terests to generous fiscal and financial incentives is stronger in more democratic host countries than in less democratic ones.FDI stock,inflows,and the associated financial openness tend to increase income inequality.41 FDI also concentrates in certain sectors,industries,and regions,leading to dual economies and with the backward sectors unlikely to take advantage of the beneficial spillovers from MNEs. Furthermore,as Oman suggests,because fiscal and financial incentives to foreign capital often occur in an insulated,bureaucratic context to facilitate successful 38.Evans1979. 39.Dunning 1993;and Oman 2000. 40.Quoted in de Soysa and Oneal 1999. 41.Dixon and Boswell 1996;Quinn 1997;and Reuveny and Li forthcoming
184 International Organization This is not to say that MNEs in more democratic countries do not have access to host governments, but MNEs' influence is likely to be balanced and diluted by various opposing groups in these countries. Conversely, where democratic institutions are weak and autocratic characteristics are strong, the host government is exposed to pressures of only limited social interests and, as Evans suggests, may resolve the dilemma by forming an alliance of the state, local, and multinational capital.38 Restrictions on political participation further prevent the losing groups from getting organized and affecting the policymaking process. Effect on fiscal and financial incentives to foreign capital. Democratic institutions also limit the generosity of the fiscal and financial incentives host countries often offer to attract foreign investors, placing more-democratic LDCs at a comparative disadvantage in the hunt for FDI. Inducements are one of many factors affecting the choice of FDI location." Examples of such inducements include tax holidays, exemptions from import duties, deductions from social security contributions, accelerated depreciation allowances, investment grants, subsidized loans, donations of land or site facilities, and wage subsidies. During the past two decades, various developing countries, regardless of their regime type, have used these fiscal and financial incentives to lure foreign capital in an increasingly vigorous competition. Even Cuban leader Fidel Castro has joined the bandwagon, remarking, "Who would have thought that we, so doctrinaire, we who fought foreign investment, would one day view foreign investment as an urgent need?04' Democratic politics matters for the design of various incentive programs. Any inducement to foreign capital, such as tax breaks or subsidies, represents a transfer of benefits from domestic taxpayers or firms to foreign investors. As noted earlier, where democratic institutions are strong, domestic players have various ways to pressure elected executives and legislators and influence policymaking. Hence, the host government is limited in its degree of freedom to supply or upgrade such incentives. Compared with more autocratic countries, more democratic host governments have a harder time obtaining the acquiescence of opposing domestic interests to the provision of generous incentives to foreign capital. Conditions particular to the LDCs also suggest that opposition by domestic interests to generous fiscal and financial incentives is stronger in more democratic host countries than in less democratic ones. FDI stock, inflows, and the associated financial openness tend to increase income inequality." FDI also concentrates in certain sectors, industries, and regions, leading to dual economies and with the backward sectors unlikely to take advantage of the beneficial spillovers from MNEs. Furthermore, as Oman suggests, because fiscal and financial incentives to foreign capital often occur in an insulated, bureaucratic context to facilitate successful 38. Evans 1979. 39. Dunning 1993; and Oman 2000. 40. Quoted in de Soysa and Oneal 1999. 41. Dixon and Boswell 1996; Quinn 1997: and Reuveny and Li forthcoming
Democratic Institutions and Investment Inflows 185 negotiation with foreign investors,the process inherently lacks transparency and accountability and often leads to graft,corruption,and rent seeking.42 In more-democratic countries,critics of FDI have greater access to political par- ticipation and hence,are more able to limit the generosity of incentives their gov- ernments offer to foreign capital.Regularly held elections,freedom of speech and association,political representation of local interests by legislators-all constitute venues through which executives'and legislatures'policies toward foreign inves- tors can be questioned,criticized,and rejected.As voters evaluate politicians based on their competence and performance in a well-functioning democracy,voters scru- tinize and quite possibly oppose overly generous incentives that do not appear to benefit the community at large.Conversely,in more-autocratic countries,social groups suffering adverse effects from FDI may be inhibited by the lack of institu- tionalized access to "veto"officeholders through election or through other open and regular channels of participation and representation found in democracies. Positive Effect of Democratic Institutions on FDI Inflows Democratic institutions in developing host countries also exert a positive effect on FDI inflows.Because democratic institutions lead to legislative representation of a wide range of social interests and facilitate political mobilization of these groups, government encroachment on private property rights is minimized.Such property rights protection is extended to MNEs,reducing risks for foreign investors and encouraging FDI inflows. Property rights protection and FDI.North defines property rights as"the rights individuals appropriate over their own labor and the goods and services they pos- sess.Appropriation is a function of legal rules,organizational forms,enforcement, and norms of behavior-that is,the institutional framework."43 Take,for example, an MNE that owns a bicycle factory in a foreign country and sells its bicycles to retail outlets in the host or home country.The host government recognizes the firm's ownership of tangible and intellectual property through legal title and protects it from a variety of threats including theft or trespass.The government also recog- nizes contracts between the factory and the retailers as legally binding,intervening to protect the rights of both parties through administrative or judicial action in cases of contract violation.Without having these rights secured,the foreign business is unlikely to invest in a host country.In general,foreign direct investors face several types of threats to their property that the host government can mitigate or exacerbate. Expropriation,which causes investors to lose their sunken assets,falls at the extreme of the spectrum.Though the likelihood of expropriation declined signifi- cantly by the early 1980s,44 theft of intellectual property is perhaps the most prev- 42.0man2000. 43.North1990,33 44.Kobrin 1984
Democratic Institutions and Investment Inflows 185 negotiation with foreign investors, the process inherently lacks transparency and accountability and often leads to graft, corruption, and rent seeking.42 In more-democratic countries, critics of FDI have greater access to political participation and hence, are more able to limit the generosity of incentives their governments offer to foreign capital. Regularly held elections, freedom of speech and association, political representation of local interests by legislators-all constitute venues through which executives' and legislatures' policies toward foreign investors can be questioned, criticized, and rejected. As voters evaluate politicians based on their competence and performance in a well-functioning democracy, voters scrutinize and quite possibly oppose overly generous incentives that do not appear to benefit the community at large. Conversely, in more-autocratic countries, social groups suffering adverse effects from FDI may be inhibited by the lack of institutionalized access to "veto" officeholders through election or through other open and regular channels of participation and representation found in democracies. Positive Effect of Democratic Institutions on FDI Injows Democratic institutions in developing host countries also exert a positive effect on FDI inflows. Because democratic institutions lead to legislative representation of a wide range of social interests and facilitate political mobilization of these groups, government encroachment on private property rights is minimized. Such property rights protection is extended to MNEs, reducing risks for foreign investors and encouraging FDI inflows. Property rights protection and FDI. North defines property rights as "the rights individuals appropriate over their own labor and the goods and services they possess. Appropriation is a function of legal rules, organizational forms, enforcement, and norms of behavior-that is, the institutional framework."" Take, for example, an MNE that owns a bicycle factory in a foreign country and sells its bicycles to retail outlets in the host or home country. The host government recognizes the firm's ownership of tangible and intellectual property through legal title and protects it from a variety of threats including theft or trespass. The government also recognizes contracts between the factory and the retailers as legally binding, intervening to protect the rights of both parties through administrative or judicial action in cases of contract violation. Without having these rights secured, the foreign business is unlikely to invest in a host country. In general, foreign direct investors face several types of threats to their property that the host government can mitigate or exacerbate. Expropriation, which causes investors to lose their sunken assets, falls at the extreme of the spectrum. Though the likelihood of expropriation declined significantly by the early 1980~,~~ theft of intellectual property is perhaps the most prev- 42. Oman 2000. 43. North 1990, 33. 44. Kobrin 1984
186 International Organization alent form of seizure in the contemporary world,with entertainment,software, pharmaceutical,and publishing firms facing significant losses.Foreign investors also worry about contract enforcement.While foreign investors could request state assistance to enforce contracts in countries lacking independent judiciaries,most firms would prefer to operate in a more transparent legal system.Government cor- ruption in a country also hinders FDI inflows.While some MNEs offer side pay- ments to government officials to avoid costly government regulation or to obtain preferential treatment,rent-seeking behaviors by government officials impose costs of unpredictable magnitude on firms,undermining not just their ability to budget or account for costs,but also the rule of law. Expropriation,seizures of assets,contract repudiation,ineffective rule of law, and government corruption all constitute violations of property rights that deter foreign direct investors.Conversely,the expectations of long-term asset security, regulatory stability and transparency,and institutionalized legal process imply less uncertainty and lower risks for foreign businesses.Better property rights protec- tion should encourage more FDI inflows. Regime type and property rights protection.Democratic institutions are on average more effective at securing private property rights than autocratic institu- tions.Typically,the state offers to protect the property rights of firms and individ- uals in exchange for their tax payments.The state monopoly on coercive power that makes property rights protection possible,however,simultaneously endan- gers the credibility of the state in the eyes of private agents,rendering the state's ex post compliance questionable.45 Why should the state follow through on its promise to respect or protect assets when no other domestic actor has access to the use of force?4 Protection by the state is not self-enforcing in that the state has an incentive not to abide by the agreement ex post under various contingencies (for example,war).47 Therefore,the provision of effective property rights protec- tion relies on a constrained state-a state with a transparent,codified legal struc- ture and institutionalized access to enforcement mechanisms. Olson and others argue that more democratic governments offer better protec- tion of private property rights.48 North and Weingast show how England's com- mitment to secure private rights became credible,as the British Parliament gained greater control vis-a-vis the Crown over fiscal policy (borrowing and taxation)and legislative and judicial power."Increasing the number of veto players implied that a larger set of constituencies could protect themselves against political assault,thus markedly reducing the circumstances under which opportunistic behavior by the government could take place."49 In addition,because the diversity of interests in 45.Olson 1993 and 2000;and North and Weingast 1989. 46.Concern for reputation and the shadow of the future are not sufficient to guarantee compliance by the state,as the latter may renege under various contingencies.North and Weingast 1989. 47.Ibid. 48.Olson 1993 and 2000;Bates 2001;and North and Weingast 1989. 49.Ibid
186 International Organization alent form of seizure in the contemporary world, with entertainment, software, pharmaceutical, and publishing firms facing significant losses. Foreign investors also worry about contract enforcement. While foreign investors could request state assistance to enforce contracts in countries lacking independent judiciaries, most firms would prefer to operate in a more transparent legal system. Government corruption in a country also hinders FDI inflows. While some MNEs offer side payments to government officials to avoid costly government regulation or to obtain preferential treatment, rent-seeking behaviors by government officials impose costs of unpredictable magnitude on firms, undermining not just their ability to budget or account for costs, but also the rule of law. Expropriation, seizures of assets, contract repudiation, ineffective rule of law, and government corruption all constitute violations of property rights that deter foreign direct investors. Conversely, the expectations of long-term asset security, regulatory stability and transparency, and institutionalized legal process imply less uncertainty and lower risks for foreign businesses. Better property rights protection should encourage more FDI inflows. Regime type and property rights protection. Democratic institutions are on average more effective at securing private property rights than autocratic institutions. Typically, the state offers to protect the property rights of firms and individuals in exchange for their tax payments. The state monopoly on coercive power that makes property rights protection possible, however, simultaneously endangers the credibility of the state in the eyes of private agents, rendering the state's ex post compliance questionable.45 Why should the state follow through on its promise to respect or protect assets when no other domestic actor has access to the use of force?" Protection by the state is not self-enforcing in that the state has an incentive not to abide by the agreement ex post under various contingencies (for example, war)." Therefore, the provision of effective property rights protection relies on a constrained state-a state with a transparent, codified legal structure and institutionalized access to enforcement mechanisms. Olson and others argue that more democratic governments offer better protection of private property rights.4X North and Weingast show how England's commitment to secure private rights became credible, as the British Parliament gained greater control vis-8-vis the Crown over fiscal policy (borrowing and taxation) and legislative and judicial power. "Increasing the number of veto players implied that a larger set of constituencies could protect themselves against political assault, thus markedly reducing the circumstances under which opportunistic behavior by the government could take place."49 In addition, because the diversity of interests in 45. Olson 1993 and 2000; and North and Weingast 1989. 46. Concern for reputation and the shadow of the future are not sufficient to guarantee compliance by the state, as the latter may renege under various contingencies. North and Weingast 1989. 47. Ibid. 48. Olson 1993 and 2000; Bates 2001; and North and Weingast 1989. 49. Ibid