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3 years ago

Productivity and Taxes as Drivers of FDI

Productivity and Taxes as Drivers of FDI

ABSTRACTWe develop a

ABSTRACTWe develop a framework in which the host country productivity has a positiveeffect on the intensive margin (the size of FDI flows), but only an ambiguous effect onthe extensive margin (the likelihood of FDI flows to occur). The source-countryproductivity has a negative effect on the extensive margin.An increase in the host-country corporate tax rate reduces the actual FDI flowsthe likelihood of such flows to occur. An increase in the source-country corporate tax ratereduces the likelihood of FDI flows. These predictions are confronted with Data on FDIflows, drawn from the International Direct Investment dataset (Source OECD), coveringthe bilateral FDI flows among 18 OECD countries over the period 1987 to 2003. We findsome support for the main predictions of the model.1

1. IntroductionForeign direct investment (FDI) is a form of international capital flows. It plays animportant role in the general allocation of world capital across countries. It is oftenpictured, together with other forms of capital flows, as shifting capital from rich, capitalabundanteconomies to poor, capital-scarce economies, so as to close the gap between therates of return to capital and enhance the efficiency of the worldwide stock of capital.This general portrayal of international capital flows may indeed pertain to FDI flowsfrom developed countries to developing countries. The latter are almost all net recipientsof FDI.However, this portrayal of international capital flow is hardly reminiscent of theFDI flows among developed countries, which are much larger than those from developedto developing countries. Although net aggregate FDI flows from, or to, a developedcountry are typically small, the gross flows are quite large.In this paper we indeed focus on bilateral FDI flows among OECD countries. Westudy the effects of two sets of driving forces that affect FDI: productivity and taxation.Specifically, we attempt to shed some light on some key mechanisms though which thesesets affect FDI flows. 3An important feature of our FDI model (which distinguishes FDI flows fromportfolio flows) is fixed setup costs of new investments. This introduces two margins ofFDI decisions. There is an intensive margin of determining the magnitude of the flows of3 Some macroeconomic studies emphasize the effect of FDI on long-run economic growth and cyclicalfluctuations. A comprehensive study by Bosworth and Collins (1999) studies a somewhat related effect:that of FDI on growth. They provide evidence on the effect of capital inflows on domestic investment for58 developed countries during 1978-1995.2

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