Do Low Corporate Tax Rates Attract Inward Investment?

It may seem like a no-brainer that low corporate tax rates will attract investment from multinational corporations. However, the empirical evidence is surprisingly scanty, and in a forthcoming article in Comparative Political Studies (earlier non-paywalled version here), Nate Jensen finds no significant relationship across OECD countries, even when he tries to control for endogeneity.

The mantra that governments must remain competitive in the global marketplace by slashing levels of corporate taxation permeates public policy debates and has influenced academic scholarship. To date, few studies have systematically analyzed the impact of lowering levels of corporate taxation on changes in FDI inflows. Utilizing dynamic tests for up to 19 OECD countries from 1980 to 2000 and isolating the impact of time-varying factors on FDI inflows, I find no empirical relationship between corporate taxation and FDI inflows. Using a number of different tax rate variables, control variables, and estimation techniques, I find no relationship between corporate tax rate changes and FDI flows. This null results remains even after using delayed tax rate changes as an identification strategy to mitigate endogeneity concerns.This result has the potential to drive the tax policy literature and the broader literature on globalization and the states in a slightly different direction.
Rather than explaining the lack of the race to the bottom by exploring how domestic politics affect tax policy, we can focus on a different question. Why, given the lack of evidence of corporate taxation affecting FDI flows, are there serious attempts at tax policy reform in many [OECD] countries, often in the name of global competitiveness? … One theory is that tax reductions are meaningful for some powerful interest groups and globalization is simply the marketing tool used to push for these reforms. … Yet there is at least one other possibility …Politicians may use tax policy as a mechanism for taking credit for new investment in the country … it is plausible that information asymmetry among voters, firms, and politicians may lead voters to reward incumbent politicians for the investments made after corporate tax cuts. … A third possibility is that politicians believe that firms respond to tax rates, and thus tax competition is driven by perceptions of the competitive environment. This incorrect belief on the importance of taxes for FDI could stem from the information asymmetries between firms and government officials.

5 Responses to Do Low Corporate Tax Rates Attract Inward Investment?

  1. The Dude December 22, 2011 at 5:01 pm #

    The aggregate FDI data from the OECD is such crap that any result based on it must be interpreted with extreme caution.

    • idiot December 23, 2011 at 1:35 am #

      Can you explain to me why the FDI data is bad and in need of extreme caution? What are the specific problems with the FDI data and how do you propose solving them? Is there another FDI dataset you would like to recommend to be used in place of the aggregate FDI data from the OECD?

      • The Dude December 23, 2011 at 11:06 am #

        One of 8328 reasons is that FDI data reflects ownership flows, not just what we typically consider ‘real investment’, so you get crazy stuff like large negative investment from island nations to the US when American firms borrow through tax havens. As Jensen points out, most recent study use the BEA firm-level data, but that restricts the sample to US multinationals. Unfortunately, there just doesn’t seem to be a good solution if you want to have a truly cross-national sample.

  2. PJR December 22, 2011 at 5:47 pm #

    The information asymmetry hypothesis brings to mind work by Mike Kimel (at AngryBear) who believes business owners plow more money back into their companies for growth when faced with high top marginal income tax rates on what they choose to take out the the company as income for themselves. He developed this conclusion after his many statistical tests showed something entirely different from the claims by politicians (with support from the business community) that high top marginal income tax rates reduce economic growth. Seems to me the business community has an incentive to NOT disclose what Kimel says and to encourage what so many politicians have been saying.

  3. Nate Jensen December 22, 2011 at 10:28 pm #

    The free (SSRN) version is pretty out of date (new robustness tests in the published version). A new SSRN version should be up soon.