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Productivity and Taxes as Drivers of FDI

Productivity and Taxes as Drivers of FDI

'This latter equation

'This latter equation defines (implicitly) an equation for the flow of FDI. As δHistypically smaller than δH, it follows that the flow of FDI declines in τH.The source-country parent firm will indulge into the project if, and only if,∗C∗ + 0H H(1 − τH) +HS(1 − τS) < (H, H, τH, ε, H) ,w L C V A K w( 18 )where τSis the corporate tax rate in the source country. Recall thatw L ∗ and C ∗HSHCHare,respectively, the host-country and source-country components of the fixed costC ∗ H.To sum up: as is evident from condition ( 18 ), the tax rate in the source country,τS, affects positively the decision by a parent firm in country S whether to carry out aforeign direct investment in country H; the tax rate in the host country, τH, has a negativeeffect on this decision. The tax rate in the source country, τS, is irrelevant for thedetermination of the magnitude of FDI flows; the latter are negatively affected by τH.As before, there is a cutoff productivity level, denoted byε τ τ( , , C ∗, ∗, 0, , , )0AH CH LH CHS KH H SwH, such that all firms with a firm-specific productivitylevel above ε0will make new investment and be acquired by FDI investors. All otherfirms will make no new investments and remain under domestic ownership. The cutofflevel of ε0is defined implicitly by ( 18 ) with the inequality sign is replaced by anequality sign. It follows from equation ( 18 ) that an increase in the source-countrycorporate tax rate ( τ S) reduces ε 0, so that more firms are purchased by FDI investors.The reason for this is that a rise in τSreduces the after-tax source-country component ofthe fixed cost. Note that V + declines in τH. But a rise in τHreduces also the after-tax,19

∗H H Hhost-country component of the fixed cost (namely, w LC (1 − τ ) ). However, if the firsteffect dominates the second, which is plausible, then an increase in τHraises ε0; that is,an increase in the host-country corporate-tax rate reduces the number of investing firms(which are also purchased by FDI investors).As before, aggregate notional FDI is given by∗C ∗ 0N( H, H H,SH, H, τH, τS, H)FDI A w L C K wε∫C∗∗ 00 ( AH , wHLH , CSH , KH , H , S, wH)ε τ τ=∗∗ C 0(H, SH, H H,H, τH, τS, ε, H) ( ε) ε ,FDI A C w L K w g d( 19 )where, as before,FDI A C w L K τ τ ε w∗∗ C 0(H, SH, H H,H, H, S, ,H)V A K τ ε w C τ K A τ ε w K+ 0 ∗ +0(H, H, H, ,H) −SH(1 −S) + (H, H, ,H) −H,=( 20 )and where K + is implicitly defined by equation ( 17 ).The actual FDI will be equal to the notional FDI only when ε0is below ε :00( , C ∗∗AH wHLH , CHS, KH, H, S, wH) ≤ .ε τ τ ε( 21 )The latter in the selection-condition equation. The actual flow of FDI ( FDI ) is thusHFDI A w L C K τ τ w∗C ∗ 0A( H, H H,SH, H, H, S, H)=∗⎧C ∗ 0FDIN( AH, wHLH , CSH, KH, τH, τS, wH) if condition ( 21) holds⎪= ⎨⎪⎩ 0 otherwise( 22 )20

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