Abstract
The paper explains the negative correlation between developing countries’ per capita incomes and measures of political risk by relating a government’s decision to tax foreign investors to distributional interests in the host country’s population. Using a dynamic general‐equilibrium model in which agents make irreversible investments abroad to insure against country‐specific technology shocks, it is shown that the political risk for foreign investors is prohibitive if the host country’s initial per capita income is too low and if the benefits of international diversification are not high enough to generate a sufficiently strong opposition against discriminatory taxation.
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