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Does Foreign Direct Investment Affect Domestic Income Inequality?

Article  in  Applied Economics Letters · February 2006

DOI: 10.1080/13504850500400637 · Source: RePEc

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Applied Economics Letters, 2006, 13, 811–814

Does foreign direct investment

affect domestic income inequality?

Changkyu Choi

Department of Economics, Myongji University, 50-3, Namgajwadong,

Seodaemungu, Seoul 120-728, Korea

E-mail: [email protected]

Using pooled Gini coefficient 1993 to 2002 data for 119 countries from

World Development Indicators 2004, World Bank, we find that income

inequality, defined as the Gini coefficient, increases as FDI stocks as a

percentage of GDP increase. Increases in per capita GDP and real per

capita GDP growth rate reduce income inequality in a country, whereas

an increase in GDP deteriorates income distribution. Furthermore, Latin

American and Caribbean countries proved to have a less equal income

distribution.

I. Motivation

The effect of globalization on income inequality has

been one of the hottest research interests as globaliza-

tion has deepened in the 1990s. There has been plenty

of research on the relationship between trade and

income inequality within countries (Chakrabarti,

2000; Wei and Wu, 2001; Carneiro and Arbache,

2003). As foreign direct investment (FDI) has

increased recently, concern about the effect of FDI

on income inequality has heightened. In this context,

Choi (2004) found a negative relationship between

bilateral FDI and income inequality between coun-

tries. This paper analyses the relationship between

FDI and income inequality within countries. On the one hand, FDI helps to reduce income

inequality when implemented to utilize abundant

low-income unskilled labour (Deardorff and Stern,

1994) or when capital, domestic or foreign, stimulates

economic growth and its benefits eventually spread

throughout the whole economy (Tsai, 1995). On the

other hand, inward FDI deteriorates income distribu-

tion by raising wages in the corresponding sectors

in comparison with traditional sectors (Girling, 1973;

Rubinson, 1976; Bornschier and Chase-Dunn, 1985;

Tsai, 1995). Based on Mexican 1975 to 1988 data,

Feenstra and Hanson (1997) found that rising wage

inequality in Mexico is associated with foreign capital

inflows. Mah (2002) investigated the impact of

changes in trade values and FDI inflows on the

Gini coefficients in Korea and concluded that

globalization tends to deteriorate the income dis-

tribution there. Taylor and Driffield (2004) also

found that inward flows of FDI contributed to

increasing wage inequality based on an empirical

analysis with the three-digit industry level for UK

manufacturing sectors over the period 1983 to 1992.

Zhang and Zhang (2003) argued that foreign trade

and FDI in China are important factors contributing

to the widening regional inequality. However, Lindert and Williamson (2001) and

Milanovic (2002) did not find any significant relation-

ship between FDI and income inequality. After

comparing models with and without geographical

dummies – such as Asia and Latin America – over the

period from 1967 to 1981, Tsai (1995) argued that

the statistically significant correlation between FDI

and income inequality might capture more of

the geographical difference in inequality than the

deleterious influence of FDI. In this paper, the effect

Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online � 2006 Taylor & Francis 811 http://www.tandf.co.uk/journals DOI: 10.1080/13504850500400637

of FDI on income distribution will be tested empirically by using updated Gini coefficient data from the World Bank.

II. Model

To test whether an increase in FDI leads to income inequality, we set up the following equation.

GINIit ¼ �0 þ �1INTENSITYit þ �2PGDPit

þ �3GDPit þ �4PGDPRit þ �5ASIA

þ �6LACþ X2002

j¼1994

�j�1994YEARj þ uit ð1Þ

where INTENSITYit¼ 100(FDIit/GDPit) and t¼ 1994, . . . , 2002.

Here subscript i represents a country and subscript t represents year t. GINI represents the Gini coefficient of a country. INTENSITY stands for foreign direct investment (FDI) stock as a percentage of GDP. PGDP, GDP and PGDPR stand for country i’s per capita GDP, GDP and real per capita GDP growth rates respectively. ASIA is a dummy variable set to one for countries in Asia and zero otherwise.1 LAC is a dummy set to one for Latin American and Caribbean countries and zero otherwise. Dummy variable YEARj is one if j¼ t and zero if j 6¼ t.

III. Empirical Results

The Gini coefficient from World Development Indicators (WDI) 2004 CD-ROM, World Bank, is used for our analysis. From 1993 to 2002, only one Gini coefficient is available for each country.

Therefore, we pooled the data for empirical analysis. The Gini index from WDI measures the extent to which the distribution of income (or, in some cases, consumption expenditure) among individuals or households within an economy deviates from a perfectly equal distribution. A Gini index of zero represents perfect equality, while an index of 100 implies perfect inequality. To get the FDI intensity, we use three types of FDI stock: inward, outward and total FDI stock. Inward and outward FDI stock, as percentages of GDP, is from the UNCTAD home- page (http://www.unctad.org). Total FDI stock as a percentage of GDP is defined as the sum of inward and outward FDI stock as percentages of GDP. Per capita GDP, GDP and real GDP growth rates are from WDI. Per capita GDP and GDP are denominated in current international dollars accord- ing to exchange rates based on purchasing power parity (PPP). The annual percentage growth rate of GDP per capita based on constant local currency is used. Statistics for the variables used are listed in Table 1.

As shown in Table 2, there are 119 observations of inward FDI stock as a percentage of GDP and 105 observations of outward FDI stock as a percentage of GDP. In all the regressions, year dummies are included but not reported. The Huber/White/ sandwich robust standard errors are reported in the parentheses.

In Equations (a)–(c) in Table 2, the Gini coefficient (GINI) is regressed on the FDI intensity (INTENSITY) and the per capita GDP (PGDP), GDP (GDP) and real per capita GDP (PGDPR) growth rates. All the coefficients turned out as expected. Notably, the coefficients of FDI intensity (INTENSITY) are positive and significant at 1%. When the FDI intensity increases, the Gini coefficient increases. This means that an increase in the FDI leads to income inequality in a country. The coefficient of inward FDI intensity is 0.116 from

Table 1. Statistics

Variable Obs. Mean Std. dev. Min. Max.

GINI 119 40.51 10.14 24.44 70.66 Inward FDI stock as a percentage of GDP (%) 119 25.38 23.79 0 154 Outward FDI stock as a percentage of GDP (%) 105 7.51 12.60 0 65 Total FDI stock as a percentage of GDP (%) 105 33.17 31.57 2 219 Per capita GDP (in thousand international dollars, PPP) 119 7.49 8.01 0.44 35.13 GDP (in billion international dollars, PPP) 119 338.77 1082.63 0.74 9641.45 Per capita GDP growth rates (%) 119 2.30 3.37 �7.36 14.6 ASIA 119 0.08 0.27 0 1 LAC 119 0.18 0.38 0 1

1ASIA includes China, Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore and Thailand.

812 C. Choi

Equation (a) and that of outward FDI intensity is

0.214 from Equation (b). The effect of FDI on

income inequality is greater in the case of outward

FDI than in the case of inward FDI. This implies that

outward FDI is associated with job losses in an

existing industry in a source country and thus leads to

more inequality than inward FDI. The coefficients of

per capita GDP (PGDP) are negative and significant

at the 1% level.2 Richer countries have more equal

income distribution. The coefficients of GDP (GDP)

are positive and significant at 1% in Equations (a)

and (c) and at 5% in Equation (b). Bigger countries

tend to have more unequal income distribution.

The coefficients of real per capita GDP growth

rates (PGDPR) are negative and significant at 1%.

Fast growing countries have more equal income

distribution.3

In Equations (d)–(f) in Table 2, we added regional

dummies, ASIA and LAC. Even though there are

minor differences in the significance level, results are

very similar to those from Equations (a)–(c).4

Coefficients of INTENSITY are positive and

significant at 5% in Equations (d) and (f) and at

1% in Equation (e). The coefficient of FDI intensity

in inward FDI is 0.082 from Equation (d) and

that of FDI intensity in outward FDI is 0.251

Table 2. FDI and GINI coefficient1,2,3

(a) (b) (c) (d) (e) (f)

Dependent variable GINI

Definition of INTENSITY Inward FDI stock/GDP

Outward FDI stock/GDP

Total FDI stock/GDP

Inward FDI stock/GDP

Outward FDI stock/GDP

Total FDI stock/GDP

Constant 49.326** 56.668** 54.833** 50.296** 57.379** 55.684** (5.089) (6.154) (5.930) (5.545) (6.506) (6.308)

INTENSITY 0.116** 0.214** 0.091** 0.082* 0.251** 0.079* (0.030) (0.072) (0.025) (0.037) (0.074) (0.030)

PGDP (Per capita GDP) �0.586** �0.802** �0.722** �0.520** �0.774** �0.645** (0.083) (0.120) (0.099) (0.086) (0.131) (0.111)

GDP 0.001** 0.001* 0.002** 0.002** 0.002** 0.002** (0.0005) (0.0006) (0.0006) (0.0004) (0.0006) (0.0005)

PGDPR (Real per capita �1.211** �1.178** �1.162** �0.767** �0.604* �0.700* GDP growth rates) (0.248) (0.266) (0.263) (0.257) (0.254) (0.272) ASIA (Asia) �0.310 �0.799 �1.375

(3.805) (3.870) (4.117) LAC (Latin American and 9.522** 11.259** 9.683** Caribbean countries) (2.376) (2.378) (2.664) Year dummies included Yes Yes Yes Yes Yes Yes R2 0.45 0.46 0.49 0.53 0.59 0.58 No. of obs. 119 105 105 119 105 105

Source: Author’s calculation. Notes: 1. ** and * indicate significance at 1% and 5%, respectively.

2: GINIit ¼ �0 þ �1INTENSITYit þ �2PGDPit þ �3GDPit þ �4PGDPRit

þ �5ASIAþ �6LACþ X2002

j¼1994

�j�1994YEARj þ uit

3. The Huber/White/sandwich robust standard errors are reported in parentheses.

2 Per capita GDP squared is added to the independent variables, but Kuznets’ ‘inverted-U curve’ hypothesis, that inequality has an inverted-U curve relationship with development (Kuznets, 1955; Tsai, 1995; Thornton, 2001), does not hold from our analysis. 3 I also added the product of rich country dummy (per capita GDP420 000 dollars) with each type of INTENSITY variable, the literacy rate, trade openness and general government final consumption expenditures as a percentage of GDP from WDI as independent variables. I could not find any significant results in relation to the Gini coefficient when these variables were added and thus those estimation results are not reported in Table 2. 4 This result is contradictory to Tsai (1995), where the effect of FDI on income inequality becomes invalid when Asia and Latin America dummies are included.

Does foreign direct investment affect domestic income inequality? 813

from Equation (e). The effect of FDI on income distribution is more detrimental in outward FDI than in inward FDI. The coefficients of the ASIA dummy are negative but insignificant. The coefficients of LAC dummy are positive and significant at 1% level. This implies that Latin American and Caribbean countries have an unequal income distribution.

IV. Conclusion

Using a pooled ordinary least squares regression, the increase in the FDI intensity measured by inward, outward and total FDI stock as a percentage of GDP proved to increase the income inequality. Especially outward FDI rather than inward FDI has more detrimental effect on income distribution. Rich countries and fast growing countries turned out to have a more even income distribution. Bigger countries tend to have a less equal income distribu- tion. Latin American and Caribbean countries have unequal income distribution.

References

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Carneiro, F. G. and Arbache, J. S. (2003) Assessing the impacts of trade on poverty and inequality, Applied Economics Letters, 10, 989–94.

Chakrabarti, A. (2000) Does trade cause inequality?, Journal of Economic Development, 25, 1–21.

Choi, C. (2004) Foreign direct investment and income convergence, Applied Economics, 36, 1045–9.

Deardorff, A. and Stern, R. (1994) The Stolper–Samuelson Theorem: A Golden Jubilee, University of Michigan Press, Ann Arbor, NI.

Feenstra, R. C. and Hanson, G. H. (1997) Foreign direct investment and relative wages: evidence from Mexico’s maquiladoras, Journal of International Economics, 42, 371–93.

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814 C. Choi

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