Foreign Direct Investment and Income Inequality in Mexico, 1990-2000

Nathan M. Jensen
Assistant Professor
Department of Political Science
Washington University in St. Louis

Guillermo Rosas
Assistant Professor
Department of Political Science
Washington University in St. Louis

Abstract: In this paper we explore the relationship between the investments of

multinational corporations (foreign direct investment) and income inequality in Mexico.
We argue that Mexico’s liberalization of foreign direct investment (FDI) inflows in the
1990s provides a natural experiment to test how FDI affects income inequality in a
middle-income country. We use an instrumental variables approach as our identification
strategy to mitigate problems of endogeneity and omitted variable bias. In an empirical
test of the determinants of changes in income inequality from 1990 to 2000, we find that
increased FDI inflows are associated with a decrease in income inequality within
Mexico’s 32 states.

Acknowledgements:
The authors would like to thank Lawrence Broz, John Freeman, Matt Gabel, Geoff
Garrett, Quan Li, Eddy Malesky, Layna Mosley, Katie Ridgeway, Pablo Pinto, John
Stringer, and Andy Sobel for comments and suggestions. Jacob Gerber and Mariana
Medina provided excellent research assistance. Thanks also to Patricio Aroca Gonzalez
for generously providing us with his data. We acknowledge the financial support of the
Weidenbaum Center on the Economy, Government, and Public Policy. Nate Jensen’s
contribution to this paper was written as a Global Fellow at UCLA’s International
Institute.

Forthcoming: International Organization 2007

1. Introduction

Globalization has distributional consequences both within and across societies. In

the areas of international trade and immigration, theoretical and empirical research has

explored how the movement of goods and people affect distributions of income.

Although considerable debate remains, existing economic models provide falsifiable

hypotheses on how trade and migration affect income distributions. Surprisingly, despite

the vast literature on multinational corporations and their investments and the increasing

activity of countries in attempting to woo foreign investment, little research has explored

the impact of foreign direct investment (FDI) on income inequality.

In this paper we argue that theoretical predictions regarding the effect of FDI on

income distribution within a country are muddled. Economic models of foreign direct

investment, usually focused on firm level decisions in response to market imperfections,

provide competing predictions of the relationship between FDI and income inequality.

We believe that measuring the net impact of FDI on income inequality becomes an

empirical question, but one that has to be approached very carefully, because potential

issues of reverse causality, selection bias, and omitted variable bias in studies of FDI can

lead to spurious results.

We focus on the liberalization of capital flows in Mexico from 1990 to 2000 and

on how the ensuing surge of multinational investments changed state-level income

inequality. Thus, we can compare Mexico pre-FDI to Mexico post-FDI and assess the

effects on the distribution of income of such capital inflows. More importantly, the

decision of most U.S. multinationals to locate close to one of the six main border routes

linking the United States and Mexico also provides spatial variation that allows us to

2
explore how levels of income inequality changed in Mexican states that attracted massive

amounts of FDI in contrast with Mexican states that attracted little FDI. This geographic

component of FDI provides us with a natural experiment: using instrumental variables

estimation, with “distance to the border” as a truly exogenous variable, we find that states

that attracted higher levels of FDI enjoyed lesser income inequality relative to states with

less FDI. We believe this strategy mitigates the serious problem of omitted variable bias.

We present our argument as follows. In Section 2, we review the extant literature

on the international determinants of inequality, especially arguments regarding the effect

of FDI on income inequality. In Section 3, we point to potential problems of endogeneity

that plague previous findings in the literature. We lay out an appropriate research design

and focus the discussion of FDI and income inequality on the case of Mexico, a middle-

income economy that benefited from increased FDI flows during the 1990s. We then

describe the construction of empirical indicators and carry out estimation of a model of

FDI and income inequality in Sections 4 and 5. We conclude by pointing out avenues for

further research in Section 6.

2. Theory

The topic of income inequality has received increasing attention within the fields of

international and comparative political economy. For starters, a lively debate currently

rages on whether patterns of economic inequality within and across nations have changed

at all over the last two decades, and if so, whether these changes can be attributed to

globalization. 1 Although a full literature review of the determinants of income inequality

is beyond the scope of this paper, we find it useful to summarize some of the

1
See Firebaugh 1999; Milanovic 2005; Sala-i-Martin 2002; Wade 2001.

3
hypothesized causal connections between globalization and economic inequality.

Following Bradley et al., we distinguish arguments as either emphasising state

institutions or global markets as the main forces driving income inequality. 2

Many scholars believe that economic distribution is ultimately shaped by

domestic factors like labor market organization and political institutions, even if changes

in international market conditions are the main cause of demands for redistribution. At

least in OECD countries, where this research program has made most inroads, studies

argue that patterns of income inequality are determined by political demands for

redistribution and safety nets, and by institutions that regulate the supply of public policy,

like party system organization. In particular, several authors have recently argued that

similar market pressures derived from globalization will translate into different public

policies and, presumably, into different patterns of income inequality. 3 The capacity of

political parties to achieve more egalitarian distributions of disposable income seems to

be constrained by patterns of labor market organization. For example, some research

suggests that highly-unionized labor markets and institutions conducive to centralized

wage bargaining allow leftist parties to achieve more egalitarian distributions of

opportunity through non-targeted social programs. 4 Alternatively, governments can

directly redistribute income through progressive income transfer policies, though it is a

2
Bradley et al. 2003.
3
See Boix 1998; Garrett 1998; Iversen 2000.
4
See Baramendi and Cusack 2004; Esping-Andersen 1990; Garrett 1998; Kenworthy

and Pontusson 2005; Pontusson, Rueda, and Way 2002; Wallerstein 1999.

4
point of debate whether such policies are possible at all under globalization. 5 Finally,

government policy can affect individual decisions regarding investment in acquiring

different types of skills. 6

Most of these studies adopt a decidedly cross-national perspective to explore

variation in domestic political institutions as a determinant of distributive outcomes. In

contrast, theoretical arguments that emphasize the role of global markets tend to

emphasize similarities across countries. For example, Rodrik argues that globalization

leads not only to a shift in demand, but also increases the elasticity of demand for labor.

As capital can credibly threaten to relocate in a global economy, the bargaining power of

labor is greatly diminished, presumably leading to wage concessions across countries. 7

Other market-based theories explore how trade or capital mobility can lead to shifts in the

demand for different factors of production. In this vein, scholars suggest that whether

international trade has a positive or negative effect on the demand for unskilled labor

depends on a country’s comparative advantage vis-à-vis trading partners. 8

Among theorists that build on the premise of comparative advantage, the common

understanding is that while the liberalization of trade and capital flows provides a net

gain for all countries, the forces of globalization generate winners and losers within the

borders of nation-states. For example, in one of the classic trade models, Stolper and

Samuelson argue that free trade would raise the incomes of the abundant factors of

5
See Bradley et al. 2003; Moene and Wallerstein 2001; Oatley 1999; Swank 2002.
6
Iversen and Soskice 2001.
7
Rodrik 1997.
8
See Wood 1994; Freeman 1995.

5
production and lower the returns to the scarce factors of production. 9 Assuming a simple

model with only two factors of production, capital and labor, there are clear distributional

implications from free trade. In countries such as the United States that have large

endowments of capital, free trade will increase the returns to capital (profits), while

decreasing the returns to labor (wages). Conversely, in developing countries with large

endowments of labor relative to capital, free trade will increase wages and decrease

profits. This leads to clear predictions on how trade affects income inequality according

to a country’s factor endowments. 10 In advanced industrialized countries (countries rich

in capital) a liberalization of trade should increase income inequality by increasing the

returns of capital and decreasing the returns to labor. Conversely, in the developing

countries, trade liberalization should decrease income inequality by increasing the returns

to labor and decreasing the returns to capital.

A second broad research agenda focuses on differences between various types of

labor, particularly skilled vs. unskilled, and how trade affects income inequality. A

number of scholars have argued that globalization has led to an increased premium for

skilled labor, thus suggesting that trade liberalization decreases the returns to low-skilled

labor and increases the returns to high-skilled labor. These arguments became familiar to

non-economists in the recent debate in the United States over the impact of NAFTA on

American workers. Although debate remains over the distributional impact of trade,

economic models provide us with theoretical tools to generate hypotheses regarding the

effects of trade on income inequality.

9
Stolper and Samuelson 1941.
10
Wood 1994.

6
 While the vast literature on the link between income inequality and trade provides

guidance on how globalization affects income inequality, one has to tread carefully in

applying these insights to the study of FDI. Foreign direct investment blossomed as a

field of study when Hymer identified the differences between foreign direct investment

and other types of financial capital.11 Hymer argued that FDI is driven by market

imperfections, rather than by factor endowments or differences in rates of return across

borders. Foreign firms have advantages over domestic firms, and they choose to locate in

a country to turn this advantage into profits, rather than export their goods or services or

license domestic firms to make the product for the multinational. One of the main

explanations for FDI is that multinationals possess intangible assets that are not easily

transferred across borders. 12

Thus, multinational corporations (MNCs) often look quite different from domestic

firms, employing more skilled workers and utilizing more advanced technologies. One

fairly consistent finding within the FDI literature is that multinationals pay a wage

premium over local firms. 13 Part of this result is attributed to MNCs locating in

industries and in urban areas that have higher median wages than the national median

wage. 14 Yet, even after controlling for factors that tend to overstate the MNC wage

11
Hymer 1976. See also Aliber 1971; Caves 1971; Dunning 1971, 1977, 1981; Hymer

1976; Kindleberger 1969.

12
Markusen 1995.
13
See Moran 1998.
14
See Klein et al. 2001; Moran 1998.

7
premium, MNCs still pay considerably higher wages than local firms. 15 This link

between multinationals and the increased demand for skilled workers has been generally

supported in the empirical literature on the impact of FDI, although most of this literature

is focused on the developed economies. 16 Most relevant for this study, Feenstra and

Hanson find that FDI into Mexico leads to increased wages of skilled workers relative to

unskilled workers and thus probably increases income inequality. 17

What does this mean for the relationship between FDI and levels of income

inequality? We emphasize two mechanisms through which MNCs may affect income

distribution within a country. First, MNCs bring capital into the country, decreasing the

total returns to capital and increasing the returns to labor. Thus, foreign capital competes

with domestic capital for domestic workers, driving up wages and decreasing the

profitability of domestic firms. This effect would speed up convergence of the incomes

of labor relative to capital, decreasing income inequality. Second, MNCs pay a wage

premium over domestic firms. If MNCs pay a wage premium for skilled workers, this

would lead to an increase in the income differential between skilled and unskilled

workers but also to diminished income disparity between skilled workers and holders of

capital. Conversely, if MNCs would hire unskilled workers and pay a wage premium for

them, FDI would decrease income inequality by raising the incomes of workers that are

most likely at the bottom of the income distribution.

15
See Te Velde 2003 for a review of the literature.
16
Hanson 2004; Te Velde 2003.
17
Feenstra and Hanson 1997.

8
 The complex relationship between FDI and income inequality becomes clear from

an overview of the theoretical determinants of FDI: for the most advanced countries, such

as the United States, Japan, or Europe, much of the cross-border FDI consists of mergers

and acquisitions. For example, the Daimler-Benz purchase of Chrysler led to a massive

flow of FDI into the United States; yet, we have little theoretical insight into how this

affected income inequality in the U.S. Perhaps more perplexing is the inflow of Japanese

FDI into the U.S. auto sector. Most scholars argue that Japanese auto manufacturers

chose to “jump” U.S. tariffs on imported automobiles and build autos in the United

States. What was the impact of this FDI on income inequality in the United States?

Clearly the success of Japanese auto producers has had some impact on Detroit, where

fierce competition has cost the city numerous highly paid auto production jobs. In

contrast, foreign car companies have built production facilities that generate high-paying

jobs in the Midwest, West, and South. Most of these foreign plants are not unionized and

pay lower wages than the unionized plants of the Big Three, but are generally located in

poor areas of the United States, generating employment and wage growth, especially in

the South.

In this paper we attempt to circumvent the existing empirical pitfalls in the study

of links between FDI and income inequality by focusing on a natural experiment in a

middle-income country. We focus on the liberalization of capital inflows into Mexico in

the mid-1990s to test the impact of FDI on income inequality. In the following section

we discuss the case.

3. Research Design

9
Few studies have directly tested the impact of foreign direct investment flows on income

inequality. One recent study by Reuveny and Li tests the impact of FDI on income

inequality in 69 countries from 1960-1995. 18 They find that although democracy and

trade decrease income inequality, foreign direct investment flows increase the level of

income inequality. Similarly, Alderson and Nielsen find a positive association between

the stock of FDI and income inequality in an unbalanced panel of 88 countries observed

at different points in time between 1969 and 1994. 19 A complete review of the literature

on FDI and income inequality is beyond the scope of this paper, yet we believe that these

studies are representative of the broader literature. 20

Though we believe it is important to address cross-national patterns of domestic

income inequality, we are slightly skeptical about the ability to test the causal link

between FDI and the distribution of income with this type of research design. In this

design, FDI is generally treated as an exogenous factor. Consider however the case of

China, which received little FDI in 1960 but is the leading FDI recipient in recent years

and where income inequality has arguably increased over the last decade. We believe

that other factors, such as economic liberalization, have an equally plausible claim to

explain the increase in income inequality in China.

18
Reuveny and Li 2003.
19
Alderson and Nielsen 1999.
20
See Te Velde 2003 for a review of the literature on FDI and income inequality in Latin

America. See also World Bank 2006 for a broad overview on the relationship between

globalization and income inequality.

10
 More formally, we can think of studies exploring the link between income

inequality and foreign direct investment as potentially suffering from omitted variable

bias, selection bias, and reverse causation. The issue of omitted variable bias is the most

transparent in the study of FDI. FDI is a firm level decision, yet most scholars study FDI

flows with models that look at country-level variables measured annually. This is

damning if omitted variables are correlated with the error term. We believe that this bias

is especially problematic in countries that enact economic reform in a bundle, liberalizing

FDI laws at the same time that they privatize state-owned enterprises and implement

sweeping trade reforms. 21 Unless appropriate indicators are included in the model

specification, any findings on the relationship between FDI and income inequality may

be capturing the impact of omitted variables on changing patterns of income inequality.

Selection bias can also lead to spurious results on the study of FDI and income

inequality. For example, an excellent study by Moran finds that MNCs, even in the most

labor-intensive industries, tend to locate their operations near pools of highly trained

labor. 22 Firms in the textile industry often invest near to or in major cities in countries

that have low national-level wages and a pool of educated labor.. At the same time, there

is an increasing skill premium generated by technological change according to recent

economic studies. 23 Thus, countries with large pools of both high- and low-skilled labor

21
See Biglaiser and DeRouen 2006; Korzeniewicz and Smith 2000 for emphasis on Latin

America.
22
Moran 2002.
23
Wood 1994. See also Tuman and Emmert 2004.

11
are most likely the countries that will have the most growth in wage inequality anyway,

independent of FDI.

Finally, there is an argument for the possibility of reverse causation. Firms could

be purposely locating in countries with high or low levels of income inequality. The

argument for firms purposely investing in countries with high income inequality is most

probable in the textile or footwear industry. In numerous countries, governments have

attracted these labor-intensive operations to export-processing zones. 24 In many cases,

governments provide exceptions for national labor laws, including the right to collective

bargaining, unions, and strikes. Even more problematic is the possibility that firms avoid

investments in countries with high levels of income inequality. As outlined by Alesina

and Perotti, higher levels of income inequality can threaten social stability and reduce

levels of domestic investment. 25 According to Jensen, investors, political risk insurers,

and plant location consultants understand that high levels of income inequality can lead

to social conflict or the targeting of foreign firms for redistributive policies. Income

inequality is a risk for firms, and this risk leads to lower levels of FDI. 26 Thus, studies of

the link between FDI and income inequality that fail to control for the possibility of

reverse causation may find a spurious relationship between higher levels of FDI and

lower levels of income inequality.

In this paper we explore how FDI impacts income inequality within a single

country. To begin with, this strategy allows us to more precisely specify our theoretical

24
Moran 2002.
25
Alesina and Perotti 1996.
26
Jensen 2006.

12
intuitions on how FDI will impact wages. We focus on the impact of FDI inflows on

income inequality in Mexico during the 1990s. Mexico underwent a rapid process of

liberalization starting with the Salinas administration in 1988, a process that eventually

led to the negotiation and implementation of NAFTA. 27 During this period of

liberalization Mexico experienced a dramatic increase in FDI inflows. We illustrate this

phenomenon in Figure 1. Note the staggering increase in FDI inflows, both as a

proportion of gross domestic product (Panel A) and in dollar terms (Panel B), after the

1989 liberalization of controls on capital flows and particularly after the 1994

implementation of NAFTA. The build-up of FDI throughout the 1990s provides us with

temporal variation to explore how the increase in FDI affected the distribution of income

in Mexico from 1990 to 2000.

—Insert Figure 1—

Furthermore, we can exploit the regional variation in FDI to address its effect on

income inequality. As in the example of China given earlier, Mexico carried out major

economic reforms, including liberalization of the financial sector, throughout the 1990s.

National changes in income inequality from 1990 to 2000 could be easily attributed to

any of several national-level policy changes or even to state-level characteristics. Yet,

the interesting regional pattern of FDI inflows gives us leverage to address the issue of

endogeneity of our FDI indicator. Most of the FDI flowing into Mexico located either in

the states bordering the United States or in Mexico City (see Map 1). 28

27
See Hanson 2005b.
28
After controlling for population density, this pattern becomes even more accentuated.

Average per capita annual flows of FDI from 1994 to 2000 amount to US $1,130 along

13
 —Insert Map 1—

It would be difficult to argue that this pattern of investment close to the U.S.

border was conditional on higher levels of education, better infrastructure, cleaner

governance, or many of the other state-level factors we would normally associate with a

good investment environment. Instead, these decisions were largely carried out based on

an exogenous factor, namely, the distance from one of the six major routes linking

Mexico to the United States. Consistent with the typical maquila pattern of FDI, U.S.

firms located in Mexico to take advantage of lower labor costs and to export finished or

intermediate products back into the United States. Spatial variation provides leverage to

evaluate how FDI inflows affected income inequality within Mexico. Unlike other

studies that ignore the endogeneity of FDI flows, we argue that while the timing of FDI

was clearly caused by factors such as Mexican trade and capital liberalizations, the actual

location of FDI was determined by an exogenous geographic factor. States that border

the U.S. received lots of FDI while the rest of Mexico, bar Mexico City, received very

little FDI.

Comparing the changing pattern of income inequality in states close to the border

as opposed to other states in Mexico provides us with a natural experiment. By using the

distance from U.S. border crossing points as an instrument explaining the decision of

multinationals to invest into different Mexican states, we can circumvent the pitfalls of

endogeneity we identified above and more persuasively estimate the effect of FDI on

the six border states (Baja California, Sonora, Chihuahua, Coahuila, Nuevo León,

Tamaulipas), but only US $311 in the rest of the country (and even this figure is

exaggerated by inclusion of Mexico City).

14
income inequality. Distance to the border is an ideal instrument, as it is highly correlated

with FDI, but there is no theoretical reason to believe that it is associated with

unobserved variables omitted from the model. We build an instrumental variable model

using the minimum distance from one of the six major land routes between the United

States and Mexico as an instrument for state-level FDI. We then estimate the changing

pattern of income inequality that follows from the decision of foreign firms to invest in

Mexican states. We minimize potential concerns about reverse causation by measuring

inequality in 1990, four years before our first available measure of FDI. We then gauge

the effects of FDI flows on income inequality in 2000.

What are our predictions about the impact of FDI on income inequality in

Mexico? As argued before, the relevant literature has explored the differential between

skilled and unskilled labor as one causal mechanism linking FDI to inequality. Feenstra

and Hanson find that FDI increased the relative demand for skilled workers and was a

driver of income inequality from 1975-1988. 29 Aitken, Harrison, and Lipsey find that

foreign firms pay a 21.5 percent wage premium for skilled workers and only a 3.3 percent

wage premium for unskilled workers. 30 Finally, most relevant for this study, Hanson

explores the relationship between the wages of working males in states with most

exposure to trade and investments (border states) with those of states with low

exposure. 31 Hanson finds that though the Mexican Peso crisis led to decreasing wages in

all regions, the low exposure states were hit much harder. Also, the distributions of

29
Feenstra and Hanson 1997.
30
Aitken, Harrison, and Lipsey 1996.
31
Hanson 2005a.

15
income shifted more to the right in the high exposure states relative to the low exposure

states. These results are mostly driven by a collapse in the incomes of employed males in

the lower income states.

While these studies provide important findings, they focus on explaining the

widening gap between skilled and unskilled labor. Our paper is concerned with the

broader question of how FDI affects income inequality, which is also driven by the

relative returns to capital and labor, along with wage differentials within the broad

categories of skilled and unskilled labor. This is not a minor point. The relative scarcity

of skilled workers in Mexico makes us skeptical about the impact of changing skilled-

labor wages on patterns of income inequality. According to the 2000 ILO survey of

Mexico, just over 6 percent of workers in the country are classified as professional or

technical workers. 32 Even though this figure clearly does not include all skilled workers,

the fact that the vast majority of workers are classified as unskilled means that the wage

differential between skilled and unskilled workers is probably only a minor determinant

of income inequality in Mexico. 33 Moreover, MNCs also pay a wage premium for

unskilled workers, as stated earlier.

32
López-Acevedo et al. 2005 analyze 2001 firm level data for Mexico and find that 71

percent of employees had no more than lower secondary school education.

33
A secondary issue is that most research focuses on the wage differences between low-

skilled and high-skilled workers. One of the motivations for attracting FDI is for the

prospects of skill upgrading. We can imagine a situation where a widening wage

difference between skilled and unskilled labor could still lead to a leveling of income

inequality if some of the unskilled workers become skilled workers.

16
 We believe instead that the major impact of MNCs will be similar to what Stolper

and Samuelson (1941) would predict. Increased FDI into Mexico will raise the demand

for skilled and unskilled workers alike. Since, as we argued above, most FDI goes into

regions close to the border, we expect reductions in income inequality produced by wage

increases for unskilled and semi-skilled workers along the Northern states.

If workers were perfectly mobile within Mexico, we would expect national wages

for low and semi-skilled workers to increase, leading to a leveling of income inequality

across the whole country. Yet, as we know, workers are never perfectly mobile even in

the most advanced industrialized economies. In Mexico, there is evidence that the lower

skilled are significantly less mobile both internally (between-states migration) and

externally (migration to the United States). 34 If workers are imperfectly mobile, regional

wage differences can arise in relation to the location of foreign firms. Thus, we believe

that the major impact of FDI in Mexico is a changing pattern of income inequality within

regions in Mexico. In the states with the most FDI, largely determined by geography, we

expect a decrease in levels of income inequality relative to the states with least FDI. Map

2 provides a first glimpse at the changing patterns of income inequality from 1990 to

2000. Note that though some states along the U.S. border have seen improvements in the

distribution of income, it is by no means obvious that FDI (as portrayed in Map 1) is

driving the process.

—Insert Map 2—

4. Income Inequality and Foreign Direct Investment Data

34
Stark and Taylor 1991. This is the same assumption used by Hanson 2005a.

17
To test our claim that FDI improves income distribution, we must construct subnational

measures of income inequality and FDI. In this section, we operationalize foreign direct

investment and state-level inequality. The income inequality indices are based on

information from the 1990 and 2000 Mexican national census; census data are publicly

available through the Instituto Nacional de Estadística, Geografía e Informática

(www.inegi.gob.mx). The actual calculation of Gini indices is based on novel methods

proposed by Milanovic 1994 and Abounoori et al. 2003. 35 These methods allow

construction of unbiased Gini coefficients from grouped income data, such as is available

from the Mexican census. 36 To construct our measures of inequality, we have had to

impose two minor restrictions to guarantee comparability between the 1990 and 2000

census. First, the 1990 census considers individuals “twelve years of age or older”,

whereas the 2000 version refers to the “economically active population” (individuals

aged twelve years or older, excluding students, housewives, and retirees). For purposes

of comparison, we consider the economically active population to comprise all

individuals twelve years of age or older. Second, non-respondents total about 5 percent

35
See Abounoori et al. 2003; Milanovic 1994. These data are detailed in Rosas 2006.
36
INEGI aggregates the census information at the municipal level and posts frequencies

by income group for the purposes of public dissemination. The data may consider a

family to be rich if it reports high income without consideration of family size. Since

poorer, rural families tend to be larger, the extent of income inequality is underestimated

(Cortés 2003, 142). A more appropriate measure should consider per capita income, but

even INEGI routinely reports inequality figures that are not corrected by family size

(Cortés and Rubalcaba 1995; Cortés 2003).

18
of all individuals in the census. We distributed non-respondents into the other categories,

according to the relative frequency of each category in each municipality.

To measure the amount of foreign direct investment at the state level, we draw on

two data sources. Patricio Aroca generously provided his data on state-level foreign

direct investment, which we have updated with information from the Dirección General

de Inversión Extranjera of the Mexican Ministry of the Economy. 37 This data measures

the dollar amount of foreign direct investment registered in any given Mexican state.

One problem in these data, pointed out by Aroca and Maloney, is that many firms register

their investments in Mexico City, yet their operations are often located in another state

(usually border states). 38 Aroca and Maloney utilize an alternative measure of FDI

(although this measure is not collected for all states) and find that the results are

consistent across FDI measures after including a dummy variable for Mexico City.

Consequently, we operationalize FDI as the average dollar value of per capita FDI flows

during the period 1993-2000. 39

5. Empirical Results

To explore the relationship between FDI and the distribution of income, we first estimate

a cross-sectional ordinary least squares regression to estimate the impact of inflows of

37
Data are available at http://www.economia.gob.mx/?P=1178 (accessed throughout

March 2006).
38
Aroca and Maloney 2005.
39
Foreign direct investment data are not available at the state level prior to 1993. Given

that the bulk of FDI entered the Mexican economy after the implementation of NAFTA,

we do not have reason to believe that this will bias our results.

19
foreign direct investment in the 32 Mexican states on levels of income inequality. Using

the OLS results as a benchmark, we then estimate an instrumental variable two-stage

least squares (IV-2SLS) regression model of the following form:

Gini2000 = β0 + β1 FDI*1993-2000 + β2 Gini1990 + β3 GSPpc1990 (1)

FDI*1993-2000 = γ0 + γ1 Gini1990 + γ2 GSPpc1990 + γ3 Education + γ4 Distance (2)

Thus, we model the level of income inequality in each Mexican state in 2000 as a

function of the level of income inequality in 1990, per capita gross state product in 1990,

and an instrument for (log) average FDI inflows from 1993-2000 (FDI*1993-2000), namely,

fitted values of a regression of FDI on excluded instruments—distance to the border and

education (average years of schooling)—and all other second-stage independent variables

as included instruments. 40 Strictly speaking, our model is overidentified through use of

education as a second excluded instrument; in this case, overidentification is necessary to

ensure that we can appropriately test the assumption of no correlation between instrument

and error process. 41 We provide summary statistics for all our indicators in Table 1.

—Insert Table 1—

We present our models based on state-level data in Table 2. Column 1 suggests

that increased levels of FDI are associated with a decrease in income inequality in an

40
Strictly speaking, the dependent variable is bounded above (1) and below (0).

However, the cross-state distribution of the Gini indices is unimodal, and even the

maximum (0.58) and minimum (0.41) values are so far from the theoretical bounds that

we are comfortable modeling E(Y|X) as a linear function of effect parameters, as in OLS

or 2SLS.
41
Baum, Schaffer, and Stillman 2003.

20
OLS model. As argued earlier, many multinationals register their operations in Mexico

City, although their production operations are located near the border. As a check on the

robustness of our results we estimate the impact of FDI inflows on income inequality in

column 2, dropping Mexico City. Our substantive results remain unchanged.

—Insert Table 2—

As highlighted earlier, FDI flows may be endogenous, making the OLS estimates

inefficient, biased, and inconsistent. Foreign investors may select production locations

based on factors such as the quality of infrastructure or prevailing state-level wages. To

mitigate these endogeneity concerns, we present in column 3 the results of an IV-2SLS

regression using the minimum distance from one of the six major border crossings and

the total number of years of education as instruments for foreign direct investment. IV

regressions have become relatively common in political science, but it is important to

note that this method is not a panacea for solving issues of endogeneity. For our

instrument to be valid, the minimum distance to the U.S. border crossing and the level of

education must be correlated with FDI inflows, and they must not be correlated with the

error term in equation 1. For our IV specifications, we include F-tests for excluded

instruments and tests of overidentification using Hansen’s J-statistic. In our IV estimates,

the F-test for excluded instruments is statistically significant at the 0.01 level, indicating

that we have valid instruments for the level of FDI inflows. Also, Hansen’s J-statistic is

not statistically significant at even the 0.1 level, indicating that we cannot reject the null

that our regressions are appropriately overidentified. 42

42
Baum, Schaffer and Stillman 2003.

21
 The results of the IV regressions, both including and excluding Mexico City, are

similar to the OLS regressions, although the magnitude of the impact is substantially

increased when compared to the OLS benchmark results. The impact of foreign direct

investment on income inequality is negative, meaning that exposure to foreign direct

investment leads to decreasing levels of income inequality. Based on coefficients from

the IV-2SLS specification, we find that a two standard deviation increase in foreign direct

investment leads to a 2.4 standard deviation decrease in income inequality from 1990 to

2000. Figure 2 illustrates uncertainty regarding the effect of FDI on income inequality by

displaying a 95 percent confidence interval around expected values. Despite large

estimation, uncertainty caused by a relatively small set of observations (32 states), we

still find that increases in foreign direct investment are associated with large reductions in

levels of income inequality, all else constant.

—Insert Figure 2—

Although our study focuses on whether or not FDI affects the distribution of

income, it is important to consider the causal mechanism linking FDI and income

inequality. One possible explanation is that FDI has led to a collapse in the incomes of

domestic capital in the border states, essentially leveling income inequality by reducing

the income of individuals at the higher end of the income distribution. Yet, Hanson finds

that it is the states with low exposure to FDI where the incomes of workers fell by 10%

and wage poverty increased 7 percent relative to high FDI states after the Mexican Peso

crisis. 43 Thus, FDI in Mexico has actually led to lower levels of income inequality in the

43
Hanson 2005a.

22
northern states, at the same time that incomes were becoming extremely unequal in the

low-exposure states.

Though we cannot speak directly to the issue of income differentials between

1990 and 2000, our data allow us to compare growth in the number of families in

different income categories. Table 3 offers a breakdown of change in the percentage of

families within each or our seven income categories in high and low FDI states. First, it

does not seem to be the case that diminished inequality is driven by a collapse in the

number of families at the upper end of the income distribution. Second, both types of

states show increases in the number of families at the upper tail of the distribution and

decreases in the lower categories. However, decreases in the number of poor families

and increases in the number of well-off families seem to be more pronounced among high

FDI states. We caution the reader that in our small sample only the numbers in income

category 3 (i.e., those reporting income of 1 to 2 minimum wages) are statistically

different across FDI categories at the 95 percent level. Though we cannot confirm which

mechanism is most important in tying FDI to diminished income inequality, evidence is

consistent with the claim that unskilled workers are benefiting the most from increased

FDI, at least if we consider that unskilled workers are more common in category 3. We

believe this evidence, specifically in the context of a natural experiment, illustrates that

FDI flows can lead to an increase in the incomes of workers and a leveling of income

inequality within states.

—Insert Table 3—

6. Conclusion

23
In this paper we explore the relationship between inflows of foreign direct investment

and changing patterns of income inequality in Mexico from 1990-2000. Using

geographic proximity to major border crossings with the United States as an instrument

for foreign direct investment, we find that inflows of foreign direct investment into

Mexican states are associated with a leveling of incomes at the state level.

These results provide new insights and possible directions for future research.

The existing studies on the link between globalization and income inequality have

focused on the impact of trade and investment on country-level measures of income

inequality. We argue that these studies suffer from serious econometric problems. Other

studies have discussed rising income inequality across regions. For example scholars

studying China lament the increasing income inequality within that country, partially

attributed to dynamic income growth in the eastern Provinces and the lagging

performance of the west and central provinces.

Yet, these studies are limited in their ability to answer the question of how

globalization maps onto these patterns of income inequality. In this project we find that

inflows of foreign direct investment into a state lead to a leveling of income inequality

within the state. This is not to say that Mexico is becoming a more egalitarian society;

many scholars have stressed that the peso crisis led to a further increase in Mexico’s

already high levels of income inequality. More importantly, diminished within-state

inequality produced by FDI may actually increase national levels of inequality. This

could occur if states that attract FDI not only become more equal, but also more

prosperous, as is likely to be the case. The spread of the national distribution of income

could become even wider as Mexican states converge on two different “clubs”, one

24
comprising mostly poor and still extremely unequal states, the other one including more

prosperous and more egalitarian states. In fact, in the 2006 presidential election, sixteen

states in the prosperous north overwhelmingly favored a candidate that espoused

adherence to markets and promised further internationalization of the Mexican economy,

whereas sixteen states in the poorer south supported a candidate that underscored

redistribution and protection from the vagaries of the marketplace.

National level studies have often linked globalization to increasing income

inequality by suggesting that openness increases demand (and returns) to high skilled

labor relative to low skilled labor. We find this mechanism to be an unlikely candidate

for explaining broad changes in the level of income inequality. This explanation is

implausible in our study of Mexico because we find that when a MNC invests in a state,

the income distribution becomes flatter within that state. We speculate that this effect

occurs through a localized increased demand for labor relative to that of capital.

Globalization could have complex effects on the distribution of income within a country,

yet we find that flows of FDI can also be associated with a reduction of income inequality

for less developed countries.

25
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 Table 1. Summary statistics

Variable Mean SD Min Max

Gini 1990 0.479 0.045 0.405 0.579
Gini 2000 0.471 0.036 0.417 0.568
1999 GDP pc (log) 2.528 0.428 1.812 3.589
FDI pc (log) 2.541 1.969 -2.843 6.067
Minimum distance to border crossing points (in miles) 441.3 171.1 15.02 749.7
Education (schooling average in years for 2000) 7.441 0.898 5.600 9.700

Table 2: State Level Results

OLS OLS IV IV
Constant 0.139* 0.182** 0.172** 0.229***
(1.92) (2.35) (2.19) (2.99)
Gini 1990 0.724*** 0.669*** 0.586*** 0.495***
(5.87) (5.55) (3.33) (2.81)
lGDPPC 0.010 0.003 0.030 0.026
(0.47) (0.901) (1.31) (1.31)
lFDI -0.010** -0.011** -0.018** -0.019***
(-2.13) (-2.11) (-2.78) (-3.18)
DF Included Yes No Yes No
N 32 31 32 31
2
R 0.79 0.80 0.76 0.76
F 49.82 51.54 31.65 31.18
Hansen J 2.425 1.116
Exc. Inst. F-test 7.90*** 7.21***
Note: All regressions estimated with robust (Huber-White) standard errors (t-statistics in
parentheses).
***=p<0.01 (two-tailed test)
**=p<0.05
*=p<0.10

32
 Table 3. Breakdown by foreign direct investment and income category

Average change (% points) in proportions of families in each income group,

1990-2000
0-0.5 0.5 to 1 1 to 2 2 to 3 3 to 5 5 to 10 +10
Hi FDI -0.024 -0.038 -0.071 0.026 0.053 0.035 0.018
(0.019) (0.032) (0.050) (0.044) (0.025) (0.016) (0.010)
Low FDI -0.017 -0.034 -0.039 0.008 0.045 0.028 0.011
(0.030) (0.029) (0.038) (0.037) (0.022) (0.010) (0.009)
a
Hi FDI states are those with above average FDI: Aguascalientes, Baja California Norte,
Baja California Sur, Coahuila, Colima, Chihuahua, DF, Jalisco, Estado de México,
Morelos, Nuevo León, Puebla, Quéretaro, Quintana Roo, San Luis Potosí, Sonora,
Tamaulipas.

33
 Figure 1: FDI over time
Panel A

3.5
32.5
FDI (%GDP)
2 1.5
1

1980 1985 1990 1995 2000

Year

Panel B
1.500e+10
1.000e+10
FDI ($)
5.000e+09
0

1980 1985 1990 1995 2000

Year

34
Figure 2: Expected Gini index conditional on per capita FDI
(95% confidence interval)

35
Map 1. Territorial distribution of FDI stock, 2000: Darker colors correspond to
higher quartiles of the distribution of FDI in Mexico.

36
Map 2. Territorial distribution of changes in state Gini indices, 1990-2000: Dark
color identifies states where inequality has increased more dramatically; light color
identifies states where inequality has decreased more dramatically. The rest of the states
have not undergone radical changes, for better or worse, in their Gini indices from 1990
to 2000.

37