Asymmetric FDI and Tax-Treaty Bargaining: Theory and Evidence

Tax treaties are often viewed as a mechanism for eliminating tax competition, however, this approach ignores the need for bargaining over the treaty’s terms. This paper makes a first attempt at modeling the conflicting goals in treaty formation by analyzing a cooperative bargaining model of tax determination. In a simple framework, we develop hypotheses about patterns in treaty tax rates. A key determinant for these patterns is the relative size of bilateral foreign direct investment (FDI) activity. In plausible situations, more asymmetric countries will negotiate treaties with higher tax rates. The implications of the model are then tested using 1992 data from bilateral tax treaties with the United States and within the OECD. We find that treaty-specified withholding taxes vary in a systematic way that is consistent with our simple bargaining model. In particular, our results highlight the importance of differences in bilateral FDI activity between the two countries. As the size of this asymmetry grows the scope for cooperation is decreased and negotiated tax rates are higher. We find similar results for relative country size. These findings indicate that it may be difficult for highly asymmetric countries to negotiate a treaty, and in fact, our analysis suggests that countries with highly asymmetric FDI activity are also the least likely to have a treaty.