Academic journal article Journal of Economic and Social Development

The Influence of the Size of the Economy and European Integration on Foreign Direct Investments in the Central, Southeastern and Eastern European States 1994-2013

Academic journal article Journal of Economic and Social Development

The Influence of the Size of the Economy and European Integration on Foreign Direct Investments in the Central, Southeastern and Eastern European States 1994-2013

Article excerpt

1. INTRODUCTION

The relationship between foreign direct investment (FDI) and economic growth is a wellstudied subject in the development economics literature, both theoretically and empirically. The interest in the subject has also grown out of the substantial increase in FDI flow that started in the late 1990's, and led to a wave of research regarding its determinants. Most of the research that studies FDI deals with the relationship between FDI and economic growth. In addition, a significant part of the research studies the determinants of FDI: economic, political and geographical. The importance of FDI in contemporary economies is well known. FDI is seen as an important element in the solution to the problem of scarce local capital and overall low productivity in many developing countries (DeMello, 1999).

With the inclusion of FDI in the model of economic growth, traditional growth theories confine the possible impact of FDI to the short-run level of income, when actually recent research has increasingly uncovered an endogenous long-run role of FDI in economic growth determination (DeMello, 1997). According to the neo-classical models, FDI can only affect growth in the short run because of diminishing returns of capital in the end. In contrast with the conventional neoclassical model, which postulates that long run growth can only happen from both the exogenous labor force growth and technological progress, the rise of endogenous growth models (Barrow and Sala-i-Martin, 1995) made it possible to model FDI as promoting economic growth even in the end through the permanent knowledge transfer that accompanies FDI.

Therefore, the importance of studying FDI has increased. Contrary to the claims that FDI boosts economic growth, Carkovic and Levine (2002) and Akinlo (2004) show that private FDI do not have significant influence on the economic growth of a state. However, the tests present in the literature about the FDI usually take into account heterogeneous groups of countries, thereby ignoring the differences that exist among these countries because of their different geographical location, tradition, and culture, as well as the trade opportunities and flows that influence the economic growth and thereby the FDI. Haufler and Wooton have studied the relation between the FDI and the tax competition, as well as the relation between the FDI and country size.

They have focused on foreign direct investment in a region in which population is asymmetrically distributed between countries and there are some remaining barriers to intraregional trade, although these are lower than on trade with countries outside the region. Empirical work has shown that both the market size and the effective tax rate on capital are important factors in influencing multinational firms' choices of countries in which to invest. Among other findings, they have shown that "if countries differ only in population size, then we would expect that it is again the largest market which attracts the firm. However, the optimal tariff or consumption tax of the largest country will now depend on its relative size vis-a-vis all other countries. Furthermore, the size of the second largest country will be critical in determining which offer the biggest country has to beat.

Essentially, the equilibrium profit tax that the largest country can extract from the firm will then depend on its market size advantage over the next largest competitor" (Haufler, Wooton, 1999). In the 1990's, studies of FDI in emerging markets have put particular stress on indicators of economic and political risk (see Lucas, 1993; Jun and Singh, 1996). This comprised three main elements: macro-economic stability, e.g. growth, inflation, exchange rate risk; institutional stability such as policies towards FDI, tax regimes, the transparency of legal regulations and the scale of corruption; and political stability, ranging from indicators of political freedom to measures of surveillance and revolutions (Dunning, 2004: 8). …

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