Fiscal decentralization, endogenous policies, and foreign direct investment: Theory and evidence from China and India

A political-economy model is developed to explain why fiscal decentralization may have a non-monotonic effect on FDI inflows through endogenous policies. Too much fiscal decentralization hurts central government incentives, whereas too little fiscal decentralization renders the local governments vulnerable to capture by the protectionist special interest groups. Moreover, the local government's preference for FDI can be endogenously polarized; therefore, a small change in fiscal decentralization across certain threshold values may lead to a dramatic difference in equilibrium FDI inflows. Empirical investigations support the idea that the difference in fiscal decentralization is an important reason for the nine-fold difference in FDI per capita between China and India. Cross-country regression results also support the inverted-U relationship.