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How tax policy and incentives affect foreign direct investment - a review

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  • Morrisset, Jacques
  • Pirnia, Neda
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    Abstract

    With an increasing number of governments competing to attract multinational companies, fiscal incentives have become a global trend that has grown considerably in the 1990s. Poor African countries rely on tax holidays, and import duty exemptions, while industrial Western European countries allow investment allowances, or accelerated depreciation. Have governments offered unreasonably large incentives to entice firms to invest in their countries? The authors review the literature on tax policy, and foreign direct investment, and explore possibilities for research. They observe that tax incentives neither make up for serious deficiencies in a country's investment environment, nor generate the desired externalities. Long-termstrategies to improve human, and physical infrastructure - and, where necessary, to streamline government policies and procedures - are more likely than incentives to attract genuine long-term investment. But more recent evidence has shown that when other factors - such as infrastructure, transport costs, and political and economic stability - are more or less equal, the taxes in one location may have a significant effect on investors'choices. This effect is not straightforward, however. It may depend on the tax instrument used by the authorities, the characteristics of the multinational company, and the relationships between the tax systems in the home country, and recipient countries. For example, tax rebates are more important for mobile firms, for firms that operate in multiple markets, and for firms whose home country exempts any profit earned abroad (Canada, France) rather than using tax credit systems (Japan, the United Kingdom, the United States). Even if tax incentives were quite effective in increasing investment flows, the costs might well outweigh the benefits. Tax incentives are not only likely to have a negative direct effect on fiscal revenues, but also frequently create significant opportunities for illicit behavior by tax administrators, and companies. This issue has become crucial in emerging economies, which face more severe budgetary constraints, and corruption than industrial countries do. The authors suggest research in five areas: 1) The eventual non-linear impact of tax rates on the investment decisions of multinational companies. 2) the effect of tax policy on the composition of foreign direct investment (for example, green-field, reinvested earnings, and mergers and acquisitions). 3) The development of new technologies, and global companies that are likely to be more sensitive to, and able to exploit incentives. 4) The need for a global approach to the taxation of multinational companies. 5) The question of whether tax incentives should be directed only at (foreign) investors thatmake the"right things"(such as environmentally safe products) or more broadly at those that bring jobs, technology transfers, and marketing skills.

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    Bibliographic Info

    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2509.

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    Date of creation: 31 Dec 2000
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    Handle: RePEc:wbk:wbrwps:2509

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    Related research

    Keywords: Public Sector Economics&Finance; Environmental Economics&Policies; Economic Theory&Research; International Terrorism&Counterterrorism; National Governance;

    References

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    1. Markusen, James R. & Morey, Edward R. & Olewiler, Nancy, 1995. "Competition in regional environmental policies when plant locations are endogenous," Journal of Public Economics, Elsevier, vol. 56(1), pages 55-77, January.
    2. Rauscher, Michael, 1994. "Environmental Regulation and the Location of Polluting Industries," CEPR Discussion Papers 1032, C.E.P.R. Discussion Papers.
    3. Haaparanta, Pertti, 1996. "Competition for foreign direct investments," Journal of Public Economics, Elsevier, vol. 63(1), pages 141-153, December.
    4. Joel B. Slemrod, 1990. "Tax Effects on Foreign Direct Investment in the United States: Evidence from a Cross-Country Comparison," NBER Chapters, in: Taxation in the Global Economy, pages 79-122 National Bureau of Economic Research, Inc.
    5. Devereux, Michael P. & Griffith, Rachel, 1998. "Taxes and the location of production: evidence from a panel of US multinationals," Journal of Public Economics, Elsevier, vol. 68(3), pages 335-367, June.
    6. Bruce A. Blonigen & Matthew J. Slaughter, 2001. "Foreign-Affiliate Activity And U.S. Skill Upgrading," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 362-376, May.
    7. Julie Collins & Douglas Shackelford, 1995. "Corporate domicile and average effective tax rates: The cases of Canada, Japan, the United Kingdom, and the United States," International Tax and Public Finance, Springer, vol. 2(1), pages 55-83, February.
    8. Desai, Mihir A. & Hines Jr., James R., 1999. ""Basket cases": Tax incentives and international joint venture participation by American multinational firms," Journal of Public Economics, Elsevier, vol. 71(3), pages 379-402, March.
    9. Goodspeed, T-J & White, A-D, 1996. "International taxation," Papers 96-11, Wellesley College - Department of Economics.
    10. Haufler, Andreas & Wooton, Ian, 1999. "Country size and tax competition for foreign direct investment," Journal of Public Economics, Elsevier, vol. 71(1), pages 121-139, January.
    11. Grubert, Harry, 1998. "Taxes and the division of foreign operating income among royalties, interest, dividends and retained earnings," Journal of Public Economics, Elsevier, vol. 68(2), pages 269-290, May.
    12. Haufler, Andreas & Wooton, Ian, 1999. "Country size and tax competition for foreign direct investment," Munich Reprints in Economics 20408, University of Munich, Department of Economics.
    13. Hartman, David G., 1985. "Tax policy and foreign direct investment," Journal of Public Economics, Elsevier, vol. 26(1), pages 107-121, February.
    14. Franklin R Root & Ahmed A Ahmed, 1978. "The influence of policy instruments on manufacturing Direct Foreign investment in developing countries," Journal of International Business Studies, Palgrave Macmillan, vol. 9(3), pages 81-94, September.
    15. David N. Figlio & Bruce A. Blonigen, 1999. "The Effects of Direct Foreign Investment on Local Communities," NBER Working Papers 7274, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Lim, Sung-Hoon, 2008. "How investment promotion affects attracting foreign direct investment: Analytical argument and empirical analyses," International Business Review, Elsevier, vol. 17(1), pages 39-53, February.
    2. Sarkar, Sudipto, 2012. "Attracting private investment: Tax reduction, investment subsidy, or both?," Economic Modelling, Elsevier, vol. 29(5), pages 1780-1785.
    3. Danielova, Anna & Sarkar, Sudipto, 2011. "The effect of leverage on the tax-cut versus investment-subsidy argument," Review of Financial Economics, Elsevier, vol. 20(4), pages 123-129.
    4. Pennings, Enrico, 2005. "How to maximize domestic benefits from foreign investments: the effect of irreversibility and uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 29(5), pages 873-889, May.

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