Fortune or Evil? The Effects of Inward Foreign Direct Investment on Corruption∗

This paper analyzes the relationship between inward foreign direct investment (FDI) and cor-ruption. Previous studies report a negative effect of corruption on FDI inflows; yet inward FDI has the potential to affect corruption levels in the host countries. We argue that the effects of FDI on corruption are conditional on the host country’s underlying economic and political climate. The underlying structure of the economy determines the possibility of extracting rents that could distributed among foreign investors and the incumbent. Political development, on the other hand, determines the level of accountability of the incumbent, and hence creates a check on the incumbent’s ability to appropriate those rents, and the probability of getting caught and sanctioned for engaging in corrupt behavior. Hence, in more democratic polities with a diversified economy, FDI inflows are likely to be associated with lower corruption. In non-democratic countries with less diversified economies, a rise in FDI inflows are more likely to be associated with higher corruption levels. Most empirical attempts to estimate the re-lationship between FDI and corruption overlook the latent endogeneity problem. We, on the other hand, construct an instrument for inward FDI per capita using a measure of remote