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Gradualism in Tax Treaties with Irreversible Foreign Direct Investment

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Author Info
Richard Chisik () (Florida International University Department of Economics)
Ronald B. Davies () (University of Oregon Economics Department)

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Abstract

Bilateral international tax treaties govern the host country taxation for the vast majority of the world’s foreign direct investment (FDI). Of particular interest is the fact that the tax rates used under these treaties are gradually falling although the treaties themselves do not specify any such reductions. Since there is no outside governing agency to redress treaty violations, such reductions must be both mutually beneficial and self-enforcing. Furthermore, the optimal tax rates must be less than those initially set, otherwise no reductions would be necessary. To explain such behavior, we model a two-country setting with two-way capital flows. In particular, only part of FDI is immediately reversible. As the extent of irreversibility increases, the likelihood of Pareto optimal tax rates obtaining as a self-enforcing outcome in the initial period is reduced. More modest tax reductions, from the non-treaty levels, are still possible. These limited tax reductions generate an increase in bilateral FDI. As countries increase the stock of capital in one another, further reductions in taxes become self-enforcing. Depending on the extent of irreversibility and asymmetry, Pareto optimal tax rates may be obtainable in the long run. Thus, the amount of inbound investment a country can attract may be related to the commitment to which its outbound investment binds it. This final insight provides an additional rationale for the observed pattern of capital flows in which those countries with the greatest outbound capital flows are also those with the highest inbound flows.

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Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2000-3.

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Length: 39
Date of creation: 01 Jun 2000
Date of revision: 01 Jun 2002
Handle: RePEc:ore:uoecwp:2000-3

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Related research
Keywords: Foreign Direct Investment Tax Treaties Multinational Enterprise Gradualism Irreversibilities Dynamic Games

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Find related papers by JEL classification:
F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
F13 - International Economics - - Trade - - - Trade Policy; International Trade Organizations
C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Rixen, Thomas & Rohlfing, Ingo, 2005. "The Political Economy of Bilateralism and Multilateralism: Institutional Choice in Trade and Taxation," MPRA Paper 325, University Library of Munich, Germany, revised 2005. [Downloadable!]
  2. Davies, Ronald B., 2003. "Tax Treaties, Renegotiations, and Foreign Direct Investment," Economic Analysis and Policy (EAP), Queensland University of Technology (QUT), School of Economics and Finance, vol. 33(2), pages 251-273, September. [Downloadable!]
    Other versions:
  3. Richard A. Chisik & Ronald B. Davies, 2003. "Asymmetric FDI and Tax-Treaty Bargaining: Theory and Evidence," Working Papers 0309, Florida International University, Department of Economics. [Downloadable!]
    Other versions:
  4. Daniel Millimet & Abdullah Kumas, 2007. "Reassessing the Effects of Bilateral Tax Treaties on US FDI Activity," Departmental Working Papers 0704, Southern Methodist University, Department of Economics. [Downloadable!]
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