Why does it Matter so Much?

hen a firm in the United States or another advanced country builds a factory, there is an expectation of revenues generated by this investment that will make the investment profitable. The owners of the firm expect to obtain the profits generated by the activities in that plant. They also expect that the firm has the right to sell the plant should it wish to do so. The firm’s owners may confront uncertainty over the profitability of the plant—the product manufactured there might not sell, or the firm’s managers might miscalculate the costs of production. But it is clear who owns the plant and has the rights to the profits that it generates. If the owners of firms are unsure if they will obtain these profits, however, they have less incentive to ensure that firms are well managed, and indeed they have less incentive to establish firms in the first place. Output in an economy is then lower. Governments take many actions that influence whether owners will indeed receive the profits from their firms. First, in most countries, governments tax the profits of firms. High tax rates reduce the return on investment. Uncertainty in tax rates also matters because it effectively lowers the return on investment activities. Economists have found that countries with high political turnover tend to be relatively slow growing. One key reason is that frequent changes in political power lead to uncertainty about tax rates. Governments can also enact more drastic policies. The most extreme example of a policy that affects the return on investment is called expropriation—the taking of property by the government without adequate compensation. Although both domestically owned and foreign- owned firms could be subject to expropriation, expropriation is more often about the confiscation of the assets of foreign investors. The World Bank has an entire division dedicated to settling disputes over expropriation. [2] For example, it is arbitrating on a $10 million dispute between a Cypriot investment firm and the government of Turkey: in 2003 the Turkish government seized without compensation the assets of two hydroelectric utilities that were majority owned by the Cypriot firm. Such settlements can take a long time; at the time of this writing (mid-2011), the dispute has not yet been settled. There are also more subtle challenges to the rights of foreign investors. Governments may limit the amount of profits that foreign companies can distribute to their shareholders. Governments may limit currency exchanges so that profits cannot be converted from local currencies into dollars or euros. Or governments may establish regulations on foreign-owned firms that increase the cost of doing business. All such actions reduce the attractiveness of countries as places for foreign investors to put their funds. Economists group these examples under the heading of property rights. An individual (or institution) has property rights over a resource if, by law, that individual can make all decisions regarding the use of the resource. The return on investment is higher when property rights are protected. In economies without well-established property rights, the anticipated rate of return on investment must be higher to induce firms and households to absorb the investment risks they face. As a consequence, countries with superior social infrastructure are places where firms will prefer to do business. Conversely, countries that have worse infrastructure are less attractive and will tend to have a lower output.