Tax sensitivity of foreign direct investment : an empirical assessment

Policy, Reseerch, and External Affairs J WORKING PAPERS Public Economics Country Economics Department The World Bank June 1990 WPS 434 Tax Sensitivity of Foreign Direct Investment An Empirical Assessment Anwar Shah and Joel Slemrod Developing counltries with heavy foreign direct investment need not worry about providing special tax incentives for foreign investment. But they must be sure that their tax system is competitive with the home tax regime of a marginal investor who has access to toreign tax credits against domestic tax liabilities. L ; \ b l he Policy. Rcseareh, and I tcrema A! !ars (rrrrnpex r d te, l'R I UA i-kIr:g Pa pers 1}d:sscmnina: te LCfindings ozf wik pors to encourage the excfhange Of ideas among Bank s:aff an*' al ohcr, rwrcstn,ed in devclorment issucs Ihcse papers carry the names of the authorm reflet O their N IC." ad 6 m d *i a -d (Ii a Pchrdng:i Ihe find:ngi. Lrtcrpretaju ns. and c,rncl.sions are r he authiirs Own 0 Ies sFriui' n"i Ih aI:nr :c,4 " Ic \i -!, 1 - li rI (f 1 ) f r rirs r,.a aagarneri. or arrn ofrs o r r errNrr Countries  Policy, Research, and External Affairs Public Economics WPS 434 This paper - a product of the Public Economics Division, Country 'conomics Department - is part of a larger effort in PRE to promote sound public policies in the development of the private sector in developing countries. Copies are available f'ree f'rom the World Bank, 1818 H Street NW, Washington DC 2()433. Please contact Ann Bhalla, room N 10-059, extension 37699 (41 pages with figures and tables). The tax sensitivity of foreign direct investment So Mexico's current policy of'dismantling (FDI) has important policy implications lor regulations and having a tax regime competitive developing countries. with that in the United States is expected to improve FDI in Mexico. If FDI is not responsive to taxation, it may bte an appropriate target for taxation b\ tihe host Mexico must aim for tax rates similar to country, which can raise revenue witihout sacri- those in thC United States to Lliminate any tax- licini4ny economic benefits f'rom FDI. induced disincentives for investment and to ward o'f anyv possible transfer of revenues from Shalh anid S;emrod examine tlhis clucstion for Mexico to the U.S. treasury/ through U.S. foreign Mexico bv modeling tlhe tax regimes in Mlexico tax credit provisions. and tie homiie couitl\ ot'a rnaroinal inmcstor. thc cr]edit siatus of l'.S. multinationils. c rount rkr AS potential investor mighl fin(d Mexico's [actors. and regulator\ anid tradle rcimes in' nicW 2 percent assets tax, because o' its partial Mexico. noncreditabililv against U.S. tax liabilities, a cause Ior coniceni. An alternative minimum tax The'\ conclude that the 1:1)1 in Me\ico is on an adjusted base that includes tax preferences sensitive to lhe iMexican and U.S. tax regimies, to as part of taxable income could achieve the same the multinationals' credit status, to counitr credit purpose but would probably be fully creditable ratinos. and to the regulatory environment. against U.S tax liabilities. Th.e PRE Working PIper Smr> diseimna.: es ith. Iindings of sork und.r \wa\ in the Bank s Policy. Research, and Extcrnal Aftl lrs C omplex. An oh.ect \e of the iern.s i to g.t these fin(tin:s out quickly. een if presentations are lcss than fuMty po,I,hed. The findings. interpretdtions. id conclusions in thf.ie papetrs (to not necessaril\' rcprcsent official Bank polics.  TAX SENSITIVITY OF FOREIGN DIRECT INVESTMENT AN EMPIRICAL ASSESSMENT Table of Contents Summary 1. Introduction .......................... .................... 1 2. Review of the Existing Empirical Literature .............. . 2 3. Unique Problems and Advantages of Studying FDI in Mexico .. 7 4. Taxation of Foreign Investment Income in Mexico ........... 10 5. Some Theory and the Empirical Model ..... .................. 15 6. The Data ............................ ...................... 21 7. Empirical Estimation and Results .............. .. .......... 27 8. Policy Implications ................... 31 Footnotes ..................................................... 34 Appendix A - The Data .................... 35 References . ................................................... 39  TAX SENSITIVITY OF FOREIGN DIRECT INVESTMENT: AN EMPIRICAL ASSESSMENT Anwar Shah and Joel Slemrod Summary Tax sersitivity of foreign direct investment (FDI) has important policy implications. If FDI is not responsive to taxation, then it may be an appropriate target for taxation by the host country, which can raise revenue without sacrificing any economic benefits FDI produces. For some countries where the degree of FDI penetration is large, this can represent a significant fraction of total tax revenues. If, on the other hand, the volume of FDI responds negatively to taxation, then the host countzy must trade off the revenue gains of increased taxation against the economic costs of discouraging FDI. The relevance of host and home country tax regimes for FDI transfers and reinvestments are the subject of considerable theoretical controversy and debate. According to the "old" view, both tax regimes matter - the home country tax system is relevant even if a subsidiary finances its investments by reinvested earnings or by raising local debt. This is because its financing and investment decisions affect home tax liability on dividends distributions. An alternative view (the so-called "new" view suggested by Hartman (1985)) argues that in the case of FDI financed by local debt or reinvested earnings, the home country tax rate is irrelevant. The reasoning is that any taxes due upon repatriation to the home country reduce equally the opportunity cost of investment (a repatriated dividend) and the after-tax return to investment. Thus it is irrelevant for the incentive to invest. Even under the new view, however, the home country tax rate would be relevant for home country multinationals that are contemplating a transfer of funds to a foreign subsidiary.  - ii - These questio.- have not yet been examined empirically for any developing country. The empirical literature on this subject primarily focuses on FDI in the USA and concludes that tax effects on FDI are quite strong. With one recent exception, none of these studies captures the home country regime in reaching these conclusions. Furthermore, in the literature, the disincentive to investment caused by the tax system is generally implicitly measured by an average tax rate, computed as total taxes paid divided by a measure of profits. However, the incentive to undertake new investment depends upon the effective marginal tax rate, which can deviate substantially from an average tax rate concept. An analysis of FDI in Mexico poses some unique problems but also offers some unique analytical advartages. Unique problems arise from the historical policy emphasis in Mexico on "regulation" (as opposed to promotion) of FDI. Unique advantages arise from the fact that the USA is a major contributor (assumed to be marginal investor) and therefore it is ssible to model the home country tax regime in examining tax effects. Having data from both Mexico and the USA make it possible to develop time series on marginal and average effective tax rates for use in this analysis. This paper examines the effects of taxation on FDI in Mexico. The empirical model used for this purposes distinguishes FDI financed by transfers and retained earnings and incorporates host and home country tax and non-tax factors including host country risk factors and credit status of multinationals. The paper concludes that empirical evidence on tax sensitivity of FDI in Mexico is quite strong. It suggests that FDI transfers and reinvested earnings respond negatively to the Mexican effective tax rate and to regulations. It is further dampened by the excess credit status of  - iii - mulsinationals. It is encouraged by a favorable economic and political climate in Mexico, as indicated by the country credit rating of The Institutional Investor and by tariffs. In view of the sensitivity of FDI to tax regime in Mexico, Mexico must aim for tax rates closer to but not lower than the U.S. rates to eliminate any tax induced disincentives for investment as well as to ward off against any possible transfer of revenue from Mexico to the U.S. Treasury through the operation of U.S. foreign tax credit provisions. Mexico has already implemented tax reforms which make the tax regime there competitive with the USA and Canada. Furthermore, effective taxation of reinvestments in Mexico is lower tinv a that of repatriations providing incentives for retained earnings The new 2-percent assets tax, nevertheless, because of its partial non-creditability against U.S. tax liability, may be a cause for concern by a potential investor. This tax could be replaced by an alternative minimum tax on an adjusted base that would include tax preferences as part of taxable income. Such a tax could achieve the same purpose as the 2-percent assets tax but would likely be fully creditable against U.S. tax liabilities. With the tax changes introduced in 1989, the Mexican tax system does not provide any special disincentives for foreign investment. In view of this, perhaps public policy attention needs now to be focussed on accelerating the process of deregulation of FDI already initiated in Mexico. An important implication of the conclusions reached here for other developing countries, especially for those where the degree of FDI penetration is lsrge, is that they need not worry about providing special tax incentives for foreign investment but must insure that their tax system is competitive with the home tax regime of a marginal investor having access to foreign tax credits against domestic tax iiabilities.  TAX SENSITIVITY OF '9REIGN DIRECT INVESTMENT AN EIIPIRILAL ASSESSMENT Anwar Shah and Joel Slemrod * 1. Introduction The 1980s have seen a remarkable growth in foreign direct investment (FDI). Along with this growth h&s come a renewed interest in its effect on economic performance (of both the host and home country) and on what is appropriate government policy toward FDI. Not surprisingly, a critical input to this debate is the responsiveness of FDI to attempts to tax the income that it produces. If FDI is not responsive to taxation, then it may be an appropriate target of taxation by the host country, which can raise revenue without sacrificing a-ny of the economic benefits that FDI produces. For some countries where the degree of FDI penetration is large, the revenue raised from taxing FDI can represent a significant fraction of total tax revenues. For example in Trinidad and Tobago, Nigeria, Pelk., Indonesia, Ecuador, and Egypt, tax payments by U.S. corporations alone aG a share of host country revenues exceed 10% (Alworth, 1988, p. 33). If, however, the volume of FDI responds negatively to taxation, then the host country must trade off the revenue gains (if any) of increased taxation against the eccno:ic costs of discouraging FDI. Most of the recent empirical literature on the tax sensitivity of FDI has focused on investment to and from the United States. Undoubtedly * This paper is the second in a series of papers commissioned by the Tax Incentives tor Industrial and Technological Development Research Project of the Public Economics Division. An earlier version of this paper was presented at the World Bank Conference on Tax Policy in Developing Countries in March 1990. We are grateful to Javad Khalilzadeh-Shirazi, Bela Balassa, Richard Musgrave, Charles McLure, Harry Grubert, and Richard Bird for comments.  - 2 - this is due to the ready availAbility of data regarding these flows. In this paper we apply and extend the standard methodology to a study of the effect of taxation on FDI in Mexico. We conclude that FDI in Mexico is sensitive to the tax regime in Mexico and of the investing countries. In addition to taxation, the regulatory framework and overall economic and political climate in the country exercise important influences on FDI transfers and reinvestments in Mexico. To arrive at these conclusions, the paper proceeds as follows. Section 2 reviews the recent empirical literature on FDI in the U.S., and Section 3 draws out the important differences between Mexico and the U.S. that are relevant for an empirical study. Sector 4 describes the tax regime for foreign investment in Mexico. Based on these insights, Section 5 p-esents an empirical framework. Section 6 outlines the data issues. Section 7 reviews the empirical results, and Section 8 offers some concluding comments. 2. Review of the Existing Empirical Literature The recent empirical literatu:e on the effects of taxation on inward foreign direct investment has focused exclusively on FDI in the United States. Interest in this topic has been stimulated of late 1by the extraordinary increase in the late 1980s of FDI into the U.S. Slemrod (1989) discusses to what extent tha; increase may be related to the tax changes in the Tax Reform Act of 1986. Because of the literature's focus on FDI into the U.S., below we first review this literature and subsequently we discuss how an empirical treatment of FDI into Mexico should be altered.  Empirical study of the effect of taxation on the time series of FDI in the U.S. was pioneered by Hartman (1984). Using annual data from 1965 to 1979, he estimated the response of FDI, sepa-ately for investment financed by retained earnings and transfers from abroad, to three variables: the after-tax rate of return realized by foreign investors in the U.S., the overall after-tax rate of return on capital in the U.S., and the tax rate on U.S. capital owned by foreigners relative to the tax rate on U.S. capital owned by U.S. investors. The first two terms are meant to proxy for the prospective return to new FDI, the first term being more appropriate for firms considering expansion of current operations and the second more spplicable to the acquisition of existing assets which are not expected to earn extraordinary returns based on production of differentiated products or possession of superior technology. The relative tax term is designed to capture the possibility that tax changes which apply only to U.S. investors will, by affecting the valuation of assets, alter the foreign investor's cost and therefore the return to acquiring the asset.1 Hartman does not attempt to measure either an effective withholding tax rate or the foreign income tax rate applied to the aggregate of foreign direct investment. He defends their absence by noting the likelihood that the average values of these tax rates are relatively constant over time. Furthermore, no attempt is made to measure the alternative rate of return available abroad to foreign investors. Hartman's regression results reveal a positive association of both after-tax rate of return variables with the ratio to U.S. GNP of FDI financed by retained earnings, and a negative association of the FDI-GNP ratio with the relative tax rate on foreigners compared to domestic  -4- residents. The model does not explain transfers from abroad as well as retained earnings, although coefficients of all three variables have the expected sign and are significantly different from zero. Hartman concludes from this research that the effect of taxes on FDI, both that implied by reinvestment of earnings and that accomplished by explicit transfer of funds, is quite strong. Boskin and Gale (1986) re-estimate Hartman's equation using the updated tax rate and rate of return series from Feldstein and Jun (1986). Although the estimated elasticities of FDI to the rates of return are somewhat lower, none of the point estimates changes by more than one standard deviation. They also extend the sample forward to 1984, and in some cases backward to 1956, and experiment with a variety of alternative explanatory variables and functional forms. They conclude that although the results are somewhat sensitive to sample period and specification, the qualitative conclusions of Hartman are fairly robust. Young (1988) uses revised data on investment, GNP and rates of return earned by foreigners to estimate similar equations. These changes increase the estimated elasticities with respecL to the rate of return realized by foreigners and the re!.