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Productivity and Taxes as Drivers of FDI

Productivity and Taxes as Drivers of FDI

country pairs with low

country pairs with low setup costs. As a result, the observed average of the FDI flows isat point M’, whereas the "true" average is at point M. As seen in Figure 1, the OLSregression line for the sub-sample is therefore the A’B’ line, which underestimates theeffect of productivity differentials on bilateral FDI flows.If we do not discard the zero FDI flow observations, the OLS estimates of β arestill biased, because they are based on observations on Y, the actual FDI, rather than onY*, the notional FDI.5. Data and Descriptive StatisticsWe consider several potential explanatory variables of the twofold decisions on FDIflows. As in Razin and Sadka (2007), these variables include standard "mass" variables(the source and host population sizes); "distance" variables (physical distance betweenthe source and the host countries and whether or not the two countries share a commonlanguage); and "economic" variables (source and host real GDP per capita, source-hostdifferences in average years of schooling, and source and host financial risk rating). Wealso control for country and time fixed effects. The dependent variable in the flowequation is the log of the FDI flows. (The flow equation is also known as the “gravity”equation.)The main variables are grouped as follows: (1) standard country characteristicssuch as real GDP per-capita, population size, educational attainment (as measured byaverage years of schooling), and financial sound rating (the inverse of financial risk23

ating); (2) (s,h) source-host characteristics, such as (s,h) FDI flows, geographicaldistance, common language (zero-one variable); (3) productivity; and (4) corporate taxrates. Productivity is approximated by labor productivity, that is, output per worker, asmeasured by PPP-adjusted real GDP per worker. This variable is at times instrumentedby the capital/labor ratio and years of schooling. Corporate taxes are measured by thestatutory rates or by the “effective” average rates, as compiled y Devereux, Griffith andKlemm (2002). The effective rates are at times instrumented by the statutory corporatetax rates and GDP per capita.Table 1 summarizes the data sources. Table 1A in the appendix describes the listof the countries in the sample and indicates for each host-source pair the (time) averageof FDI flows as percentages of the host and source GDP. Some source countries do notinteract with more than with few host countries. We do not smooth the data by takingmulti-year averages, but rather employ unfiltered annual data. This enables us toinvestigate the effects of the explanatory variables over the business cycle. In the text wepresent in Table 2 some aggregate statistics of the detailed country-pair data of Table 2A.Specifically, we consider all the EU countries, except the U.K. and Ireland, as one blockof countries. We then present (time) average flows among this block, the U.K., theU.S., Ireland, and Japan as percentages of the host and source country/block GDP. Thisunderscores the prominence of the U.S. as a source of FDI and the U.K., Ireland andJapan as recipients of FDI. Note that the EU (excluding the U.K. and Ireland) plays arelatively small role either as a source or host of FDI.Data on FDI flows are drawn from the International Direct Investment dataset(Source OECD), covering the bilateral FDI flows among 18 OECD countries over the24

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