The Effects of Corruption on

The surge in foreign direct investment (FDI) flows during the 1990s has motivated a host of recent studies into their determinants. Recently, the level of corruption in the host country has been intro-duced as one factor among the determinants of FDI location. From a theoretical viewpoint, corruption—that is, paying bribes to corrupt government bureaucrats to get “favors ” such as permits, investment licenses, tax assessments, and police protection—is generally viewed as an additional cost of doing business or a tax on profits. As a result, corruption can be expected to decrease the expected profitability of investment projects. Investors will therefore take the level of corrup-tion in a host country into account in making decisions to invest abroad. The empirical literature on the effects of the host country’s cor-ruption level on FDI inflows, however, has not found the commonly expected effects. Some empirical studies provide evidence of a neg-ative link between corruption and FDI inflows, while others fail to find any significant relationship. Most existing studies use a cross-sectional rather than a panel data analysis to examine the effects of a complex phenomenon. Such a method cannot control for the unobserved country-specific effects Cato Journal, Vol. 29, No. 2 (Spring/Summer 2009). Copyright © Cato Institute. All rights reserved. Ali Al-Sadig is an economic researcher at the Saudi Arabian Monetary Agency (SAMA). He thanks Timothy Hatton and George Symeonidis for supervising his dis-sertation, upon which this article draws. He also acknowledges helpful comments from Santos Silva and from participants at the Research Student Seminar