The Effect of Foreign Direct Investment on Income Inequality

Abstract

This paper empirically examines the relationship between foreign direct investment (FDI) and income inequality. I regress income inequality on inward FDI stock using an unbalanced panel of 170 countries for the period 1980-2019 using a time and country fixed effects ordinary least squares (OLS) regression model. I find that there are no significant effects of inward FDI on the measure of income inequality in the destination country. Supposing that the insignificant result could be masking some heterogeneity within the sample, I introduce several dummy variables for different types of economies. I find that when the destination of the FDI is “poor,” FDI reduces income inequality in the destination. When the destination is an Eastern European EU member country, FDI increases income inequality in the destination. When the destination is an emerging market economy, FDI reduces income inequality in the destination. I also use a recent data set that specifies the specific source of the FDI in addition to the destination of the FDI (bilateral data). I introduce dummy variables for four types of source countries (high-income, upper middle-income, lower middle-income, and low-income) to investigate the heterogeneity of effects on income inequality based on the origin of the FDI. Using an unbalanced panel of 170 countries for the period 2001-2012, I find that when the source country is high-income and the destination is “rich,” FDI increases income inequality in the destination. I also find that when the source country is upper middle-income and the destination is “poor,” FDI increases income inequality in the destination. The results for poor destination countries are conflicting between the initial specification and the bilateral specification in which the source countries are disaggregated by income group, most likely due to discrepancies between the data sets and missing observations of FDI flows for certain source countries.