Foreign Direct Investment and Policy Stability of Environmental Regulations in Polluting Sectors

ABSTRACT Foreign direct investment (FDI) is a significant source of economic growth. Two important factors for attracting FDI are endogenously determined environmental policies and domestic policy stability, which we define as the ability of policymakers to continue established policies. We contribute to the literature by investigating the welfare implications of attracting FDI in a polluting sector where a government chooses a pollution tax given a policy stability level. We modify Helpman et al.'s (2004) FDI model with heterogeneous firms to determine the optimal pollution taxes and the welfare implications with or without FDI. Our model includes a heterogeneous polluting sector, a homogeneous non‐polluting sector, consumers negatively affected by pollution, and a policymaker who has a positive probability of being removed from office. We find that the pollution tax is higher when the polluting sector opens to FDI across all policy stability levels compared to the closed sector case. The pollution tax rate is reduced when the policy stability level increases. Welfare is generally higher when not allowing FDI in the polluting sector. The welfare loss due to uncertainty is reduced as the policy stability level increases because we approach the socially optimal pollution tax level. The difference in realised welfare between the closed and open FDI polluting sector cases is largest when there is low marginal pollution damage, high foreign entry cost, or a high elasticity of substitution.