FOREIGN DIRECT INVESTMENT, INDUSTRIAL LOCATION AND CAPITAL TAXATION
Luis Lanaspa Fernando Pueyo Fernando Sanz (*)
Faculty of Economics University of Zaragoza (Spain)
ABSTRACT
This paper demonstrates from a theoretical point of view that governments can affect the location decision of firms by using the tax rate on capital income as a policy instrument. Furthermore, we find that, in general, countries with a lower tax burden are net receivers of foreign direct investment.
Keywords: capital taxation, international allocation of capital
JEL Classification: F21, H73, R12
(*) Corresponding author:
Fernando Sanz Facultad de Ciencias Económicas Gran Vía, 2 50005 Zaragoza (Spain) Phone: 34 976 761 830 Fax: 34 976 761 996 E-mail:
[email protected]
1. INTRODUCTION
The increasing liberalisation of international capital mobility has intensified the debate, at both academic level and amongst public entities, on the effects that capital taxation has over its spatial location. In this line, the empirical works of Hartman (1984), Boskin and Gale (1987), Slemrod (1990), Swenson (1994) and Devereux and Griffith (1998), amongst others, have made clear that the location and investment decisions made by firms are not neutral in the face of the different tax rates that are levied in individual countries. The relative abundance of applied works that confirm the importance of tax rates contrasts with the absence of theoretical works undertaken in this area. Against this background, the aim of this paper is precisely to contribute towards remedying this lacuna and, to that end, we introduce capital taxation in a standard model of Economic Geography as represented by that of Martin and Rogers (1995). Traditionally, the motives that justify foreign direct investment are related to the existence of externalities or market imperfections that are internalised or eliminated, respectively, by the multinational firm. The theoretical analysis carried out in this paper places emphasis on a third significant motive, namely the distortions introduced by government policy. These policies, which can take the form of tariffs (in this respect, see Dehejia and Weichenrieder, 2001), subsidies or taxes can create conditions under which it is more profitable to produce in, rather than export to, a foreign country. Thus, with capital becoming more mobile internationally, capital flows in a country and the corresponding location of industries depend, amongst other things, on the domestic and the foreign capital tax rate in such a way that a capital flight from high to low tax countries can occur.
2. THE MODEL
Let there be two countries, home (H) and foreign (F), where in each country the representative consumer maximises the following utility function: U=
Dα Y1-α α α (1 − α ) 1− α
0K, then the domestic country is the net receiver of foreign direct investment and viceversa. Following some algebra, the four earlier expressions lead to:
(K + K )[L (ρ + ρ ρ )(ρ (1 − t )− ρ ρ (1 − t ))− L (ρ + ρ ρ )(ρ (1 − t ) − ρ ρ (1 − t ))] + −n= L (ρ − ρ ρ )(ρ (1 − t )− ρ ρ (1 − t )) + L(ρ − ρ ρ )(ρ (1 − t ) − ρ ρ (1 − t )) *
*
n
*
D
*
D
I
* I
I
* I
* D
2α
+
(
* D
σ
)( (
*
I
*
I
* I
* D
* I
* D
I
I
* I
* I
D
D
* I
I
I
* I
*
(1 − t )(1 − t * )(ρD ρ*D − ρ2I ρ*2I )(K * L − KL* )
)
) (
)(
(
*
L* ρD − ρI ρ *I ρ *D 1 − t * − ρI ρ *I (1 − t ) + L ρ*D − ρ I ρ *I ρD (1 − t ) − ρ I ρ *I 1 − t *
))
(6)
3. CAPITAL TAXATION AND INDUSTRIAL LOCATION
3.1. Symmetric countries In this case, (6) becomes: ρ + ρ I ρ *I t − t * , n − n =2K D * * ρD − ρI ρI 2 − t − t 2
*
(7)
in such a way that n*>n if and only if t* 0, ∂t
(8)
4
and, as a consequence, and increase (decrease) in the tax rate of a country repels (attracts) foreign direct investment. Finally, it can immediately be proved that: ∂ ( n * −n ) > 0 ⇔ t* < t , ∂ρ I*
(9)
so that better international infrastructures suppose an increase in the number of firms in a given country if and only if this country has a lower tax burden. The reason for such a situation is that, with a reduction in transport costs, the negative effects on demand derived from locating abroad lose their importance, in such a way that firms are more sensitive to fiscal incentives.
3.2. Countries with different domestic infrastructures Particularising, expression (6) leads to: n − n = 2K *
(ρ
(ρ
D
D
(
)
ρ*D + ρI2 ρ*I 2 )(t − t * )+ 2 ρI ρ*I ρ *D (1 − t* )− ρD (1 − t )
ρ +ρ ρ * D
2 I
*2 I
)(2 − t − t ) − 2 ρ ρ (ρ (1 − t )+ ρ *
I
* I
* D
*
D
,
(1 − t ))
(10)
from which it can be deduced that if t* ρD(1-t) then n*>n. As a consequence, F captures foreign direct investment if its tax rate is lower and if its domestic infrastructure net of taxes is superior. Therefore, within this framework governments that are interested in attracting foreign firms (or avoiding the flight of national firms) can use tax incentives to compensate for possible deficiencies in the domestic transport infrastructure. In turn, (8) continues to be verified and, confirming the results already deduced in Martin and Rogers (1995), it holds that an improvement in the domestic infrastructures of a country unequivocally attracts firms; in effect, from (10) we derive that: ∂( n * − n) >0 ∂ρ D*
∂ ( n * − n) K and > 0 if K>K* . (13) ∂t * ∂t Thus, if one country possesses more capital than the other, the effect of the respective tax rates on the number of firms is the expected one. In this way, for the country with the higher endowment of capital it is beneficial, as regards the number of firms, to reduce the tax rate.
4. CONCLUSIONS
International capital mobility has increased significantly in recent years. As a consequence, it becomes interesting for governments to implement economic policy measures aimed at attracting these investments within their respective frontiers. In this paper we have shown that, from a theoretical point of view, an appropriate instrument to achieve this objective is the correct choice of tax rates on capital incomes. Thus, we have demonstrated that firms, when deciding on their location, are sensitive to different tax rates, in such a way that those countries with a lower tax burden are net receivers of foreign direct investment.
6
REFERENCES
Boskin, M. J. and W. G. Gale, 1987, New results on the effects of tax policy on the international location of investment, in: M. Feldstein, ed., The effects of taxation on capital accumulation, (University of Chicago Press, Chicago) 201-222. Dehejia, V. H. and A. J. Weichenrieder, 2001, Tariff jumping foreign investment and capital taxation, Journal of International Economics 53, 223-230. Devereux, M. P. and R. Griffith, 1998, Taxes and the location of production: evidence from a panel of US multinationals, Journal of Public Economics 68, 335-367. Giovannini, A., 1990, International capital mobility and capital-income taxation. Theory and policy, European Economic Review 34, 480-488. Hartman, D. G., 1984, Tax policy and foreign direct investment in the U.S., National Tax Journal 37, 475-488. Martin, P. and C. A. Rogers, 1995, Industrial location and public infrastructure, Journal of International Economics 39, 335-351. Slemrod, J., 1990, Tax effects of foreign direct investment in the United States: Evidence from a cross-country comparison, in: A. Razin and J. Slemrod, eds., Taxation in the global economy, (University of Chicago Press, Chicago). Swenson, D., 1994, The impact of US tax reform on foreign direct investment in the United States, Journal of Public Economics 54, 243-266.
7
