Foreign Direct Investment abd Trade: substitutes or complements

The relationship of FDI and trade has attracted extensive attention from economists over the past few decades. A large portion of the existing empirical literature supports the theory of substitution, which argues that FDI flows have a negative effect on trade. Other studies find that the effect is positive, endorsing the theory of complementarity. This thesis addresses the problem of endogeneity that arises mainly because of reverse causality and proposes the corporate income tax rate as an instrument for FDI. The dataset consists of 32 countries, covering the 1995-2011 period. Bilateral country and year fixed effects are included in the 2SLS estimations. FDI flows appear to have a negative and significant effect on exports while the proposed instrument passes the necessary tests. The results suggest that the nature of the relationship between FDI and trade is substitutional