GDP | Global Development Perspective

Working Paper No. 21.003

May 25th, 2021

Wages, labor quality, and FDI inflows: a new non-linear approach

Lei Hou, Qi Li, Yanfei Wang, Xintong Yang

Abstract Although theory predicts that locations with lower wages will attract more FDI inflows, the empirical results from traditional linear regression models are rather mixed. We consider the possible impact of labor quality, along with wages, and build a simple FDI location choice model to capture the potential nonlinear relationship among the three. Further, we propose a partially linear panel data model to investigate the wage effect on FDI location choices. Using macroeconomic province-level data from China between 1993 and 2018, we find that the marginal effect of wage is generally a decreasing function of labor quality. This implies that facing low labor quality, FDI firms prefer locations with high wages that ensure high labor quality; while facing high labor quality, their preferences for low labor costs dominate. Our nonlinear approach reconciles the mixed results in the empirical literature on how wages affect FDI inflows and the role of labor quality in attracting FDI.

Key words FDI, wage, labor quality, partially linear regression

JEL classification F21, J31

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