Corporate taxation and FDI within the EU25 Amina Lahrèche-Révil CEPII 2nd EUROFRAME Conference on Economic Policy Issues in the European Union Vienna, Friday 3 June 2005

What do we know? Traditional tax competition literature –Increasing integration  pressure on tax policies –Small countries more prone to tax competition –Race to the bottom ? EU enlargement context Imperfect competition –Trade costs + scale economies  home bias, higher taxes in the largest countries (Haufler & Wooton, 1999) –Agglomeration economies  agglomeration rents, tax competition = limit pricing (Baldwin & Krugman, 2004)  Do tax differentials really affect FDI?

The enlarged EU What may happen in the EU? –Increasing integration  competition? –Small (competition) vs. large countries (agglomeration) What happens in the OECD? –Tax differentials do affect FDI location decisions – But only higher taxes divert FDI –Non-linearity according to the size of tax differentials and the double-taxation regime in the investor’s country. –Competition from third countries

Outline Stylized facts Econometric methodology Results Conclusion

Decreasing statutory corporate taxes in the UE15...

… and in the NEM

Convergence in (mainly statutory) tax rates

Ex-post taxation is more cyclical - NEM

EU15

FDI flows mostly to the EU15

Empirical analysis Theoretical foundations tax = cost  FDI should react But Transfer pricing and intra-firm debt  profit  location Tiebout (1956): taxation and public-goods provision Markusen (1995): structural determinants > taxation High tax = high pre-tax return Imperfect competition: taxes = location rents Empirical literature Semi-  : -3.3/-4.0, high variance ( De Mooij & Ederveen, 2003 )

Estimation strategy Bilateral, gravitational setting, market potential , annual Tax measurement: statutory + ex-post taxation (GDP/VA) Results Gravity significant, distance < 0 Statutory not significant, ex-post significant and < 0

Cost and competitiveness1 Unit labor cost differential +/or bilateral real exchange rate  7 positive  higher costs attract more FDI (labor quality?)  8 positive  improved competitiveness attract FDI  7 +  8  no sign change Tax variables not very robust Tax < 0 with competitiveness

Cost and competitiveness2 Geographic dummy When d  EU15  relative ULC significant, positive When d  NEM  bilateral real exchange rate, positive With both variables, relative ULC only for EU15. RER for both but elasticity higher for NEM. Taxation Statutory taxation not significant Ex-post taxation significant.

ULC mostly affect EU15, RER the NEM

Taxation only impacts FDI in the EU15...

… but things are not so simple1  Higher taxes in the recipient divert FDI

… but things are not so simple2  Higher taxes the NEM divert FDI   Incentive for lowering taxes

Further problems: competitors’ taxes1

Competitors’ taxes2 FDI is diverted by higher taxes in the recipient, but attracted by lower taxes in the recipient, compared to its (distance-weighted) competitors

Conclusion1 Orders of magnitude: tax competition and geography 1% point change in competitors tax differential must be compensated for by a 1.4 % point change in the opposite direction in the recipient country  sizeable a 1 sd increase in the market potential can be compensated for by a 3.1% points increase in the apparent tax differential in the recipient country  even more sizeable