Our paper adapts contemporary trade theory to identify a key structural determinant of the political choices that governments make when taxing and regulating foreign and domestic investors. We argue that when the cost of starting up production in a new country is high, foreign investors receive better treatment by the host government and more easily dominate domestic competitors. Our political economy model, with endogenous entry and exit by foreign investors in response to policies chosen by a strategic government, formalizes the effects of startup costs.
Since the host government can only take from foreign investors that actually produce in its market, it must treat foreign investors in high startup cost industries favorably lest it drive all foreign investors from the market. Therefore, market entry is a key determinant of government treatment, despite scholars' long-time focus on market exit and asset mobility. But at the same time, when the host government treats foreign investors better, less productive foreign investors can enter, and disadvantaged domestic competitors must be relatively more productive to survive. We use firm- and industry-level data in up to 293 disaggregated industries in 207 countries to demonstrate the theory's implications for government treatment in the form of taxes, as well as indicators of success for foreign and domestic firms. Our paper establishes a new measure of industry-level variation in political risk, crucial for our understanding of political constraints and their effects on not just foreign, but also understudied domestic firms.
Professor Leslie Johns received her Ph.D. in 2008 from the Department of Politics at New York University. She also holds a B.F.A. and M.S. from Carnegie Mellon University. Her research focuses upon the use of international organizations to resolve interstate disputes. Her work has appeared in journals such as International Organization and Journal of Conflict Resolution.
Prof. Johns is also the author of Strengthening International Courts: The Hidden Costs of Legalization (Univ. of Michigan Press, 2015).