The Influence of Taxes on Inflows and Outflows of Foreign Direct Investment

Abstract

The article discusses the effectiveness of tax incentives for regulation of the level of foreign direct investment inflows (FDI) and outflows in the economy. Theoretically, changes in tax levels should influence both the profitability of investment projects and companies’ choice of locations for their production units. At the same time, transfer pricing opportunities in the world economy may neutralize the effects of tax changes on the level of countries’ FDI inflows and outflows. The aim of the research is to study empirically the influence of tax levels in countries on bilateral FDI flows. Methodologically, this study relies on regression analysis. Two variables indicating the tax level of the economy are used: the share of total taxes on income, profits and capital gains and share of taxes and social contributions in total government revenues. The database includes observations over 71 recipients and 91 home countries in 2001–2016. The gravity approach is applied to construct the econometric model while the Poisson pseudo maximum likelihood method is used to derive unbiased estimates. The main results of the research are as follows. First, there is a negative relationship between the tax burden and level of FDI inflows to the country. Second, higher taxes lead to an increase in FDI outflows only in the countries with relatively low taxes, while in countries with relatively high taxes the opposite dependence is observed. Third, vertical (efficiency-seeking) FDI are much more sensitive to the level of taxes in the recipient country compared with horizontal (market-seeking) FDI. We have not found any evidence for the positive influence of tax differentials on bilateral FDI. The conclusion is made that tax regulation measures may be an efficient instrument for stimulating FDI inflows to the national economy. For citation Drapkin I.M. The Influence of Taxes on Inflows and Outflows of Foreign Direct Investment. Journal of Tax Reform . 2020;6(3):244–255. DOI: 10.15826/jtr.2020.6.3.084. Article info Received August 12, 2020 ; Revised September 1, 2020 ; Accepted October 22, 2020