Fiscal Decentralization, Endogenous Policies and Technology Adoption: Theory and Evidence from China and India's FDI

A political economy model is developed to explain why two developing economies with the same economic fundamentals can have different de facto economic policies toward FDI (viewed as foreign better technology) and, as a result, receive starkly different amount of FDI inflows. I show how fiscal decentralization can have both a non-monotonic and dramatic impact on policies and FDI. Too much fiscal decentralization may hurt the incentives of the central government hence it would choose the policy profiles to induce the local governments to block FDI. Too little fiscal decentralization may render the local governments captured by the protectionist special interest group. The policies toward FDI are therefore sufficiently favorable only when fiscal decentralization is on some medium range. I show that the equilibrium FDI may bifurcate because the local government's induced preference for FDI could be endogenously polarized, consequently a small change in fiscal decentralization might diametrically shift the local government's attitude, leading to dramatically different institutional entry cost imposed on FDI. The simulation/calibration results closely match China and India's data for the macroeconomic and policy variables. Counterfactual experiments also indicate that the degree of fiscal decentralization can well explain China and India's nine-fold difference in FDI per capita although these two economies are at the similar development stage.