Productivity with Endogenous FDI Spillovers: A Novel Estimation Approach

Abstract

The paper develops a new methodological framework for evaluating the role of FDI in the domestic economy. We firstly propose a measurement of Total Factor Productivity (TFP), which accounts for endogenous FDI knowledge spillovers. Our estimation allows knowledge spillovers to co-evolve with output and inputs selection, ensuring that the estimated production inputs are consistent whilst correctly identifying performance improvements. After deriving unbiased TFP measures at the firm level, we aggregate them at the industry level to search for reallocation effects driven by the FDI presence. Our methodology distinguishes between within-firm gains and industry reallocation effects from FDI. We apply our novel framework to a sample of 7699 manufacturing firms from six EU countries. The main findings are: (i) endogenous FDI spillovers correct for the omitted variable bias in the estimation of production inputs; (ii) inter-industry spillovers are important sources of TFP gains; (iii) the realization of gains from FDI knowledge spillovers are dependent on the absorptive capacity of the firm (iv) higher levels of FDI presence in the local economy can contribute to aggregate TFP increases as much as 33%. The paper offers the basis for considering new policy perspectives on FDI incentives and suggests new approaches for modeling the mechanisms through which domestic firms can experience productivity gains from their interaction with foreign counterparts in a globalized business environment.