Cato Online Forum

More and Better Foreign Direct Investment

National output is a function of the quantity and quality of both labor and capital deployed in the economy, tempered by the constraints and leveraged by the advantages of the environment in which they are deployed. That’s just another way of saying legal institutions, business culture, and the policy environment matter, too. Economic growth requires that all of these determinants, interacting in the aggregate, move output in a positive direction.

With the world’s largest, most innovative, and most dynamic economy for most of the past century, U.S. officials could afford to be cavalier about their policy mistakes and to defer reform for another day. In most cases, those errors and their collective drag on the economy were barely, if at all, perceptible. The engine of growth was working well enough to compensate for its inefficient design and poorly inflated tires.

But it appears that the engine’s main components are wearing down and replacement parts may be hard to come by.  In a recent paper, Brink Lindsey suggests that long-term U.S. growth in real GDP per capita will likely fall from its historical average of about two percent per year because each of the four discrete growth components has been declining (quantity of labor and capital) or stagnating (quality of labor and capital) in recent years without any foreseeable prospects to reverse those trends. In light of these hard facts, Lindsey implies that the time may be ripe for policy changes — to inflate the tires, change the oil, and remove the sand from the gears. He writes:

“In the quest for new sources of growth to support the American economy’s flagging dynamism, policy reform now looms as the most promising ‘low-hanging fruit’ available.”

There is probably no single elixir to reverse the declining long-term U.S. growth rate. Getting significantly more mileage out of our labor and capital likely will require a variety of reforms. Among them should be measures that expand the potential for economies of scale, such as deepening global economic integration through harmonization of regulations and standards, removing tariffs on industrial inputs and final goods, and eliminating barriers to services trade. Two “mega-regional” trade negotiations that could yield that outcome are currently in progress.

But the priority developed in this essay is for policymakers to focus on making the United States a more attractive location for foreign direct investment. The United States is competing with the rest of the world for investment in domestic value-added activities, and foreign providers of that capital have demonstrated the capacity to raise averages across a variety of economic metrics, including GDP.

According to a study published by the Organization for International Investment, U.S. subsidiaries of foreign headquartered companies (or U.S. “affiliates”) represent less than 0.5 percent of U.S. companies with payrolls, but punch well above their weight, accounting for 5.9 percent of private-sector value added; 5.4 percent of private-sector employment; 11.7 percent of new private-sector, non-residential capital investment; and 15.2 percent of private-sector research and development spending. These affiliates earn 48.7 percent more revenue from their fixed capital and compensate their employees at a 22.0 percent premium compared to their respective U.S. private sector averages.

Between 2001 and 2010, U.S. private-sector value added increased by 39 percent; for affiliates the increase was 56 percent. In the manufacturing sector, affiliates proved even more consequential: while overall U.S. manufacturing-sector value added increased by 21 percent over the decade, it rose by 53 percent for manufacturing-sector affiliates. Affiliates increased their stock of U.S. property, plant, and equipment by 46 percent over the decade — double the overall private-sector rate of increase. The list of superlatives goes on.

Affiliates have raised average U.S. economic performance by boosting output, sales revenue, exports, employment, and compensation. They have also demonstrated stronger than average long-term commitments to operating in the United States with increasing levels of capital investment, reinvested profits, research and development spending, and cultivation of relationships with U.S. suppliers. Moreover, U.S. companies have benefitted from exposure to the best practices employed by affiliates, many of which are world-class companies that have stood out in their home markets and have what it takes to succeed abroad.

Competitive jolts to established domestic firms, technology spillovers, and the hybridization and evolution of ideas have all been positive consequences of the infusion of foreign direct investment. One can only wonder whether the Detroit automakers would still be producing Ford Pintos, AMC Pacers, and Chrysler K-Cars had foreign producers not begun investing in the United States in the early 1980s, helping to reinvigorate a domestic industry that had fallen asleep at the wheel.

No country has ever been a stronger magnet for FDI than the United States. Valued at $4.9 trillion in 2013, the U.S. stock of inward FDI accounted for 19 percent of the world total — more than triple the share of the next largest single country destination. However, the U.S. share was a whopping 39 percent only 15 years ago. Since then, annual inflows have failed to establish an upward trend.

To some extent, this development reflects inevitable demographic changes. Strong economic growth over the past 15 years in developing countries has followed periods of political stability and economic liberalization, creating new opportunities and inspiring greater confidence that these formerly high-risk bets are desirable places to invest in productive activities. However, another important reason for the declining U.S. share is the deteriorating U.S. investment climate.

Companies looking to build or buy production facilities, research centers, and biotechnology laboratories consider a multitude of factors, including access to skilled workers and essential material inputs; ease of customs procedures; the reliability of transportation infrastructure; legal and business transparency; and the burdens of regulatory compliance and taxes, to name some. According to several reputable business-perception indices, the United States has slipped considerably over the past decade in a variety of these areas.

Out of 142 countries assessed in the World Economic Forum’s Global Competitiveness Index, the United States ranks 24th on the quality of total infrastructure; 50th on perceptions that crony capitalism is a problem; 58th on the burden of government regulations; 58th on customs procedures; 63rd on the extent and effect of taxation. Meanwhile, ongoing uncertainty over energy, immigration, trade, tax, and regulatory policies continues to deter investment, while encouraging U.S. companies to offshore operations that might otherwise be performed in the United States.

In a recent paper, Harvard Business School professors Michael E. Porter and Jan Rivkin wrote:

“The question ‘Where should we locate?’ is more prominent in the minds of executives than it has ever been. Over the past three decades, business activities have become increasingly mobile, and more and more countries have become viable contenders for them. As a result, the number and significance of location decisions have exploded. Considerable evidence suggests that the U.S. is not winning enough of the location decisions that support healthy job growth and rising wages.”

Although high-end activities such as advanced manufacturing and research and development have been U.S. strengths over the years, Porter and Rivkin worry that the United States has been struggling to attract and retain those activities. They attribute the loss of location decisions to bad public policies:

“The U.S. government is failing to tackle weaknesses in the business environment that are making the country a less attractive place to invest and are nullifying some of America’s most important strengths.”

The authors surveyed nearly 10,000 Harvard Business School alumni about their experiences with location decisions. Citing a complex tax code, an ineffective political system, a weak public education system, poor macroeconomic policies, convoluted regulations, deteriorating infrastructure, and a lack of skilled labor, survey respondents expressed great concern that business conditions in the United States were eroding relative to other countries. Putting the United States in a stronger position to win more investment location decisions requires better understanding of the determinants of these decisions and how public policies affect them.

Last year, the Global Investment in American Jobs Act of 2013 was passed in the House of Representatives.  The Senate has not yet considered the bill, but one of its cosponsors, Senator Bob Corker (R-TN), remarked: “If we want the U.S. to be the very best place in the world to do business, we need to take a close look at what we’re doing right, what we’re doing wrong and how we can eliminate barriers that diminish investment in the U.S.”

The “Findings” section of the legislation states the importance of foreign direct investment to the U.S. economy, acknowledges that the U.S. share has been declining in the face of growing competition from other countries, and calls for a comprehensive assessment of the policies that both repel and attract foreign investment. The bill’s premise is that U.S. policy and its accumulated residue have contributed to a business climate that might be deterring foreign investment in the United States, and that changes to those policies could serve to attract new investment. Whether through this bill or some other vehicle, the concept of a comprehensive policy audit to identify the most fruitful reforms followed by quick implementation makes good sense.

Considering that the United States has the highest corporate tax rate among OECD countries and an extraterritorial system that subjects corporate earnings abroad to punishingly high rates upon repatriation, tax reform would likely make the list. The Peterson Institute’s Gary Hufbauer and Martin Vieiro argue in a recent paper that “[r]educing the U.S. corporate tax rate is certainly the most efficient way to encourage domestic investment and associated gains in production and jobs.”

Investment deterrents can be found in the millions of pages of the U.S. Code and the Federal Register. According to the Competitive Enterprise Institute, the cost of compliance with federal regulations reached $1.863 trillion in 2013. In January 2011, President Obama issued Executive Order 13563 under the heading “Improving Regulation and Regulatory Review.” Section 1 states:

“Our regulatory system must protect public health, welfare, safety, and our environment while promoting economic growth, innovation, competitiveness and job creation. It must be based on the best available science. It must allow for public participation and an open exchange of ideas. It must promote predictability and reduce uncertainly. It must identify and use the best, most innovative, and least burdensome tools for achieving regulatory ends. It must take into account benefits and costs, both quantitative and qualitative. It must ensure that regulations are accessible, consistent, written in plain language, and easy to understand. It must measure, and seek to improve, the actual results of regulatory requirements.”

Certainly, a comprehensive audit would identify regulatory overkill as an important impediment to investment. President Obama (or his successor) should be prepared to reissue Executive Order 13536, but with a much greater sense of urgency and seriousness, including external reviews with goals and firm deadlines included.

If incoherent U.S. energy policies — policies that leaves investors guessing about whether and to what extent gas and oil exports will be restricted next year or the year after, and about whether solar energy will be subsidized or taxed in 2015 — are found to be deterring investment, policy remedies must be implemented. If U.S.-based producers are disadvantaged by higher production costs than their foreign competitors on account of the customs duties they must pay for raw materials and components, permanently eliminating all duties on production inputs should be an option on the table.

If a dearth of skilled workers is cited as an investment deterrent, the spotlight should be shone on U.S. education and immigration policy failures with the goal of finding the right solutions. If liability risks on account of wayward class-action suits and legal system abuses are keeping investors at bay, major tort reform should be seriously considered.

Foreign direct investment is a verdict about the efficacy of a country’s institutions, policies, and potential. Given the importance of FDI to economic growth, understanding its determinants and crafting policy accordingly is a matter of good governance and common sense.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

Daniel Ikenson is the director of the Herbert A. Stiefel Center for Trade Policy Studies at the Cato Institute.