For the past few decades, many developing economies are integrating rapidly into the world market. This rapid integration has led to a heavy influx of foreign capital in the form of foreign direct investment into these economies. Foreign direct investment (FDI) has been sought by many developing economies as a means to augment their endowment of domestic capital, source of advanced technology, better managerial practices, efficiency gains, and access to new foreign markets. Hence, most of the developing economies are seeking to enhance the level of foreign direct investment in their economies.
However, the distributional consequences of increasing foreign capital inflows are also widely debated in the literature. The studies in the empirical literature has put forward different contending theoretical perspectives on the impact of FDI on host countries (see Tsai, 2005; Figini and Gorg, 1999; Meschi and Vivarelli, 2007, etc.). A theoretical perspective supporting modernization theory implies that foreign capital inflows lead to a decrease in income inequality, whereas those supporting dependency theory imply that foreign direct investment leads to an increase in income inequality. Another perspective based on the Aghion and Howitt (1998) model implies that FDI follows non-linear relationship with income inequality.
A vast theoretical literature has developed based on general equilibrium models, which points out the impact of foreign capital inflows on wage inequality. There are two kinds of studies in this literature. One set of studies examines the impact of foreign capital inflows on wage inequality with supply of skilled labor to be fixed and given. Banerjee and Narayan (2011), Marjit and Kar (2011), Gilbert and Beladi (2011), Beladi, Chaudhuri, and Yabuuchhi (2008), Chaudhuri and Yabuuchi (2007), and Chaudhuri(2008) found that the impact of foreign capital inflows on skilled–unskilled wage inequality depends on factor intensity condition of the sectors. Besides this, the impact is also found to be dependent on other factors such as type of good (i.e., intermediate or final good) produced in the non-traded sector (Chaudhuri and Yabucchi, 2008), efficiency function of skilled working class (Chaudhuri, 2011; Chaudhuri and Banerjee, 2010), and importance of environment quality (Pan and Zhou, 2013).
Another set of studies examines the impact of foreign capital inflows on wage inequality with supply of skilled labor to be endogenous.