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Abstract

This article shows how policies to attract foreign direct investment (FDI) in a polluting sector affect home-country welfare relative to the autarky case. We consider a welfare maximizing country who attracts FDI into a polluting sector, while accounting for environmental quality changes. The government sets the level of environmental regulation and public infrastructure. Foreign investors prefer good infrastructure quality and less environmental regulation. We show that under autarky, environmental regulations are increasing over infrastructure. However, with FDI, optimal environmental regulations may be a subsidy if the benefits from a wage increase outweigh the damages from pollution. Also, we find that if a country has very poor levels of infrastructure it is better off not allowing FDI to enter but as infrastructure quality increases, the result is reversed where welfare with FDI is higher than under autarky.

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