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Do Low Corporate Tax Rates Attract Inward Investment?

- December 22, 2011

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”:http://cps.sagepub.com/content/early/2011/12/15/0010414011428594.abstract in _Comparative Political Studies_ (earlier non-paywalled version “here”:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=955713), Nate Jensen finds no significant relationship across OECD countries, even when he tries to control for endogeneity.

bq. 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.

bq. 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.