Bureaucratic corruption, environmental policy and inbound US FDI: theory and evidence

Previous studies have proposed that equilibrium capital flows are affected by environmental regulations—the commonly coined ‘pollution haven’ hypothesis. We revisit this issue by treating environmental policies as endogenous and allowing governmental corruption to influence foreign direct investment patterns. Via these two simple extensions, we are able to provide a much richer model of international capital flows. The theoretical model presumes that the effect of corruption on FDI operates via two channels: corruption affects capital flows through its impact on environmental policy stringency and due to greater theft of public funds earmarked for public spending. We empirically examine the implications of the model using US state-level panel data from four industrial sectors over the period 1977–1987. Empirical results suggest environmental policy and corruption both play a significant role in determining the spatial allocation of inbound US FDI. In addition, the estimated effect of environmental policy is found to depend critically on exogeneity assumptions.