How Does FDI React to Corporate Taxation? Old and new results

1
How Does FDI React to Corporate Taxation?Old
and new results

• Conference on  Tax competition in the EU25 
  Prague, December 16-17, 2004
• Agnès Bénassy-Quéré Lionel Fontagné and Amina
  Lahrèche-Révil
• CEPII

2
Factor mobility and tax competition

• Traditional tax competition literature
• Increasing integration ? pressure on tax policies
• Small countries more prone to tax competition
• Race to the bottom ? EU enlargement context
• Imperfect competition
• Trade costs scale economies ? home bias, higher
  taxes in the largest countries (Haufler Wooton,
  1999)
• Agglomeration economies ? agglomeration rents,
  tax competition limit pricing (Baldwin
  Krugman, 2004)

3
Evidence on taxes and FDI

• Why shouldnt FDI react to taxes?
• Transfer pricing and intra-firm debt ? profit ?
  location
• Tiebout (1956) taxation and public-goods
  provision
• Markusen (1995) structural determinants gt
  taxation
• High tax high pre-tax return
• Imperfect competition taxes location rents
• Empirically MNF do react to tax incentives
• Double-taxation rules
• repatriated profits importance of tax treaties

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Focus

• ? Does FDI really react to tax incentives (WP1)?
• ? How does it react exactly (WP2) ?
• ? What happens in the enlarged EU (WP 3)
• Look at
• Tax differentials (not tax levels)
• correct for double taxation rules
• Positive / negative tax differentials
• nonlinearities

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FDI and tax variables

• Sample
• 11 OECD countries (9 EU countries Japan US) /
  25 EU countries
• 1984-2000 (2002 for EU) ? panel data analysis
• Constant FDI in dollars
• Tax variables
• Statutory tax rates
• Apparent tax rates receipts/taxable income
• Ex-ante measures (effective average/marginal tax
  rates)

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Gravity variables

• Market potential (? FDI) ( enlarged MP)
• Size of the investing country (PPP) (? FDI)
• Distance (?)
• Fixed costs lt trade costs ? locate close to
  markets, and FDI increase with distance (FDI
  substitute to trade)
• Fixed costs transaction and information costs ?
  detrimental to FDI and trade
• FDI complementary to trade ? distance detrimental
  to both
• Common language (? FDI)

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Additional variables

• Relative unit labor costs
• Bilateral real exchange rates (in level)
• Public expenses in the host country
• Share of public investment in total public
  expenses
• Fixed effects on investors and hosts

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Baseline estimates - comments

• ? market potential attracts FDI (demand effect)
• ? increases outward FDI (supply effect)
• Distance not significant / common language
  significant
• Higher taxes in the recipient country always
  discourage FDI significantly
• Tax differentials can compensate for location
• 10 disadvantage in market potential ? 5 points
  lower statutory tax rate

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Baseline estimate - Results
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Checking robustness

• Potential endogeneity of effective taxation to
  FDI
• Apparent tax differentials instrumented using
  their lagged values or statutory tax
  differential. Estimates robust
• Cost variables wrongly signed (appreciation /
  increase in ULC ? increases FDI)
• Balassa-Samuelson (RER / GDP) quality of labor
• Public expenses
• No impact of volume higher share of investment
  attracts FDI taxation has less impact (higher
  tax rates compensated for by public-goods
  attractiveness?)

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Taxation in third countries

• MNF arbitrate between several potential locations
  ? the whole vector of tax differentials should
  matter
• weighted average of taxes in alternative
  locations (using the inverse of distance)
• Tax differentials in EATR not significant, but
  potential collinearity with bilateral tax
  differentials
• Results much more significant using ex-post
  taxation
• Higher taxes in the host/investor discourages
  FDI, but higher taxes in third countries increase
  FDI to the host

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Non-linear impact of tax differentials

• Do double-taxation rules have an impact on the
  sensitiveness of FDI to taxation?
• Hypothesis higher impact when the exporter
  applies exemption
• Excess foreign tax credit not reimbursed
• ? only higher taxes abroad should discourage FDI
  stemming from crediting countries
• Costly relocation tax uncertainty tax
  deferrals
• ? Higher sensitivity to large tax differentials

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Tax schemes

• Hypothesis not confirmed
• Same impact for exemption or credit
• Hines Rice (1994) same results for investors in
  the US
• A possible explanation lower tax rates in
  crediting countries (except Japan)
• MNF mostly feel a disincentive to invest abroad

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Negative vs. positive tax differentials (1)

• Coefficient on positive tax differentials larger
• A higher tax rate in the host is more harmful to
  inward FDI that a lower tax rate is attractive
  for FDI
• ? FDI more sensitive to tax disincentives

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Negative vs. positive tax differentials (2)

• Firms form crediting countries only react to
  positive tax differentials
• But same asymmetric behavior for firms
  originating from exempting countries
• ? No major risk of tax competition FDI does not
  react to lower taxes abroad. But strong incentive
  for high-tax countries to lower the tax burden to
  attract FDI

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Non-linearities (1)

• Sources of non-linearities
• Complexity and instability of tax codes ?
  information about taxation highly imperfect
• Costly relocation
• Tax deferrals, partial tax avoidance
• ? Large differentials should matter more
• 3-steps estimations

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Non-linearities (2)
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Non-linearities (3)

• Tax differentials and cubic tax differentials
  negative
• Impact stronger with larger tax differentials
• Investors react linearly when exemption react to
  large tax differentials when credit
• Only positive tax differentials matter
• ? Tax disincentives more powerful than tax
  incentives
• ? Convergence in tax rates when investors in
  exemption

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Quantification

• Market potential versus tax differential
• Credit vs. exemption
• 1 sd increase in market potential ? 31 increase
  in FDI inflows
• investor in credit ? 7 points tax rent for
  recipient
• Investor in exemption ? 10 points tax rent for
  recipient
• Impact of nonlinearities
• Investor in exemption ? 7 points tax rent for
  recipient
• investor in credit ? 24 points tax rent for
  recipient

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Conclusion

• NEG tax competition ? zero taxation (taxable
  rents)
• Our findings FDI does react to tax differentials
• Conclusion
• No zero taxation structural determinants matter
  incentive to cut taxes falls on high-tax
  countries
• Asymmetry between exempting/crediting countries
  incentive for tax competition depends on the
  geographical composition of FDI
• EMU mostly exemption rules
• ? convergence of tax rates to the lowest level?

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Tax competition in an enlarged EU

• Similar Focus
• Tax differentials
• Positive versus negative tax differentials
• Third countries?
• Sample heterogeneity? ? EU15 versus NEM

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Stylized facts

• Decreasing corporate taxation in the EU25,
  especially for statutory tax rates

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Estimation strategy

• Bilateral, gravitational setting, market
  potential
• 1990-2002, annual
• Tax measurement statutory ex-post taxation
  (GDP/VA)
• Results
• Gravity significant, distance lt 0
• Statutory not significant, ex-post significant
  and lt 0

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Cost and competitiveness (1)

• ULC differential /or bilateral RER
• ?7 positive ? higher costs attract more FDI
  (labor quality?)
• ?8 positive ? improved competitiveness attract
  FDI
• ?7 ?8 ? no sign change
• Tax variables
• not very robust
• Tax lt 0 with competitiveness

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Cost and competitiveness (2)

• Geographic dummy
• When d ? EU15 ? relative ULC significant,
  positive
• When d ? NEM ? bilateral real exchange rate,
  positive
• With both variables, relative ULC only for EU15.
  RER for both but elasticity higher for NEM.
• Taxation
• Statutory taxation not significant
• Ex-post taxation significant.

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ULC mostly affect EU15, RER the NEM
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Taxation only impact FDI in the EU15
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but things are not so simple
? Higher taxes in the recipient divert FDI
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Further problems competitors taxes (1)
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Competitors taxes (2)
FDI is diverted by higher taxes in the recipient,
but attracted by lower taxes in the recipient,
compared to its (distance-weighted) competitors
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Conclusion

• EU25 is different
• Distance
• But higher taxes divert FDI in the NEM, as in
  OECD
• Orders of magnitude tax competition and
  geography
• 1 point change in competitors tax differential
  must be compensated for by a 1.4 point change
  in the opposite direction in the recipient
  country ? sizeable
• a 1 sd increase in the market potential can be
  compensated for by a 3.1 points increase in the
  apparent tax differential in the recipient
  country ? even more sizeable