How Tax Policy and Incentives Affect Foreign Direct Investment

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How Tax Policy and Incentives Affect Foreign Direct Investment

A Review

By Jacques Morisset1 And Neda Pirnia

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Foreign Investment Advisory Service (FIAS), a joint service of the International Finance Corporation and the World Bank. The opinions and arguments expressed are the sole responsibility of the authors and do not necessarily reflect those of the above institutions. We would like to thank Bijit Bora, Gokhan Alkinci and Carl Aaron for their comments. To be published in “New Directions for Research in FDI”, B. Bora (ed), Rutledge, forthcoming

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I.

Introduction

In a world where an increasing number of governments compete hard to attract multinational companies, fiscal incentives have become a global phenomenon. Poor African countries rely on tax holidays and import duty exemptions, while industrial Western European countries allow investment allowances or accelerated depreciation (Table 1). This trend seems to have grown considerably since the early 1990s as evidenced by the number of high profile foreign investments, such as Toyota in Northern France or Mercedes-Benz A.G. in the U.S. State of Alabama. These have generated considerable debate about whether governments have offered unreasonably large incentives to entice those firms to invest in their area. Still, this debate about the effectiveness of tax incentives is hardly new and has accumulated a long history.2

The objective of the paper is to review the existing literature on tax policy and Foreign Direct Investment (FDI) as well as to explore possibilities for future research. Taxes affect the net return on capital and should, at least in the mind of numerous policymakers, influence the capital movements between countries. For this reason, the early literature attempted to evaluate if a generous tax policy could compensate for other obstacles in the business environment and, thus, attract multinational companies. In the mid-1980s, the literature went one step further by exploring what kind of tax instruments should have the greatest impact on the location decision of multinational companies. Special attention was also given to the motivations and tax behavior of the multinational company.

In recent years, the globalization process has led to the emergence of new issues. Not only have companies tended to become more mobile, but also governments have to deal with this new dimension in the design of their national tax policy. The gradual

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According to Wells (1999), the earliest reference was in 1160, when wool weavers were offered tax incentives to locate in Biella, in the Piedmont region of Northern Italy.

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elimination of barriers to capital movements have stimulated governments to compete for FDI in global markets as well as reinforced the role of tax policy in this process. This recent competitive trend has to be offset by the increasing pressure that governments face to harmonize their tax policies within regional (or international) agreements. A second important issue has been the recognition that tax policies of the home and host countries are interconnected and that this link influences the behavior of multinationals. There has been a great deal of evidence, especially after the changes in the U.S. tax laws during the late 1980s, that home country tax policy affects both the multinational firm’s behavior and the effectiveness of tax policy in the countries where these firms operate and invest. Last but not least, there has been a growing attention to the costs associated with tax incentives –and not only to their possible benefits. Tax incentives are likely not only to have a direct negative impact on fiscal revenues but also, and frequently, create significant possibilities for suspicious behaviors from tax administrations and companies. This issue has become crucial in emerging countries where budgetary constraints as well as corruption are certainly more severe than in industrial countries.

Table 1...
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