The Effect of Taxation on Foreign Direct Investment

«Countries with higher tax rates, stiffer capital controls, and greater
propensity for ordinary bus
iness transactions to entail corrupt payments
are those that receive the 
least FDI, controlling for other factors.»

While there exists an emerging consensus that tax policies significantly
influence the volume of FDI, there is very little agreement over the precise
magnitudes of tax effects and the way in which these magnitudes may have
evolved over time.

This is an issue of first-order importance, since the effects of tax policies
on national welfare depend critically on the extent to which tax rate changes
have the ability to influence FDI flows.

A study  by Rosanne Altshuler, Harry Grubert, and Scott Newlon,
analyzes firm-level tax information on the location of foreign investment
by American manufacturing firms in 1984 and 1992.

The study finds that the location of property, plant, and equipment
is highly sensitive to tax rates:
Controlling for other considerations, 10 percent higher tax rates are
associated with 15 percent less investment in 1984 and 30 percent less
investment in 1992.

These results are important for at least two reasons.

The first is that they document a degree of sensitivity of FDI to local tax
rates that is at the very high end of the existing quantitative literature.
The second is that they indicate that the sensitivity of FDI to taxation has risen
over time. This greater sensitivity is consistent with the incentives created
by the U.S. statutory tax rate reductions introduced by the Tax Reform
Act of 1986, as well as with the globalization of American business and the
consequent greater ability to relocate productive operations in response to
tax incentives.

Foreign direct investment involves parties in at least two countries, so
the tax policies of both home and host governments have the ability to
influence the pattern of FDI.
These tax policies are often coordinated, as when home governments provide
“tax sparing,” which is the practice of adjusting home-country taxation of foreign
investment income to permit investors to receive the full benefits of any host-country
tax reductions.

For example, Japanese firms investing in countries with whom Japan has
tax sparing agreements are entitled to claim foreign tax credits for income
taxes they would have paid to foreign governments in the absence of tax
holidays and other special abatements. Most high-income, capital-
exporting countries grant tax sparing for FDI in developing countries,
while the United States does not.
Comparing  Japanese and American investment patterns we
find that the ratio of Japanese FDI to American FDI in countries with
whom Japan has tax sparing agreements is roughly double what it is else-
where.
In addition, Japanese firms are subject to 23 percent lower tax rates
than are their American counterparts in countries with whom Japan has
tax sparing agreements.
Similar patterns appear when tax sparing agreements with the United Kingdom
are used as instruments for Japanese tax sparing agreements.
This evidence suggests that tax policy in general, and tax sparing in particular,
influences the level and location of FDI.
Furthermore, the home-country provision of tax sparing appears to influence the
willingness of host governments to offer tax concessions.
Host governments impose on foreign investors various obligations, of
which taxes represent a subset (albeit a very important one). Other poten-
tially important obligations and restrictions include capital controls and
any obligations to make payments to corrupt government officials.
An analysis by Shang-Jin Wei, shows  the distribution of foreign direct
investment by fourteen major capital-exporting countries in forty-five host
countries as of 1991.

The patterns are instructive:
Countries with higher tax rates, stiffer capital controls, and greater
propensity for ordinary bus
iness transactions to entail corrupt payments
are those that receive the 
least FDI, controlling for other factors.

The estimates imply that the effect of corruption on FDI is so strong that the difference
between the environment of Singapore (which has very little official corruption) and that of
Mexico has an effect on FDI equivalent to a 29 percent tax rate difference.
There is no evidence of any important interactions between the effects of
corruption levels and those of tax rates, suggesting that investors are no
more able to escape high tax burdens in more corrupt countries than they
are in less corrupt countries.
U.S. states tax business activity at different rates, and the responsiveness
of foreign direct investment to these tax rate differences offers useful evidence
in evaluating both the likely impact of cross-country tax rate differences and
the effect of state tax rates on purely domestic investment.

The results indicate that FDI types differ greatly in their responsiveness
to state tax rates.

High state tax rates discourage the location of new plants or
expansions of existing plants, while encouraging FDI that takes the form of
acquisitions of existing firms.

These results are generally consistent with the growing literature
on the substantial effects of subnational taxation on the location of FDI,
while calling attention to the heterogeneous forms that FDI takes and the
likelihood that tax effects vary by type of FDI transaction.

Nickolas C. Papanikolaou

Source : James R. Hines Jr

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