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01 Apr 2001

Foreign Direct Investment and Corporate Income Taxation in Europe

Agnès Bénassy-Quéré / Lionel Fontagné / Amina Lahrèche-Révil

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European Network of Economic Policy Research Institutes Working Paper No. 4, 45 pages

The growing globalisation of OECD economies, associated to the progresses in European integration, tends to increase the mobility of capital and to deepen the pressure on tax policies. On the one hand, tax policies are tied by the Stability Pact criteria: the limit imposed on budget deficits leaves little scope for tax rates to decrease. On the other hand, the growing mobility of capital tends to increase the elasticity of tax bases to tax rates, hence reducing the autonomy of governments in increasing taxes.

In this particular context, tax interdependencies are rising between countries and regions. Two issues are of particular concern, and could have different outcomes depending on the way they are tackled. First, countries could engage in an action on tax levels; depending on whether this action is co-operative or not leads to tax harmonisation or tax competition. Second, countries could have to reconsider fiscal schemes, since the growing interdependence of countries tends to dissociate the notions of residence and source of revenue, and rises an incentive for tax evasion (namely, when exemption schemes are applied, profits taxes are paid in the country where the investment is located; investors are therefore incited to locate their affiliates in low tax countries. Conversely, when credit schemes are applied, foreign investors pay their home country taxes, and there is no particular incentive to evade the national tax system).

The issue of fiscal harmonisation is all the more stringent that the scope for tax competition is enhanced with EMU (intra-European exchange rate risk disappears with the euro, which considerably reduces impediments to trade, FDI and labour mobility, and increases the mobility of the tax bases). In the area of corporate taxes however, the scope for competition will depend on the sensitiveness of firms to tax discrepancies across possible locations (for instance, if agglomerations economies are dominant, tax competition would have a negligible impact).

Hence there is a need to assess the importance of taxes in the decision of firms to allocate their activities abroad. This paper provides an econometric analysis of the sensitivity of inward foreign direct investment (FDI), in some OECD countries, to tax rates and to tax regimes. It is shown that inward FDI is negatively affected by a rise in effective as well as nominal corporate tax rates. This result holds, be the fiscal regime (exemption/credit) controlled or not.

These results are used to perform some simulations which allow to quantify the impact on inward FDI of a tax competition and of a change in tax schemes in Europe. It is shown that the generalisation of credit schemes in Europe would reduce inward FDI in our sample of countries, because it would remove the opportunity to evade high tax rates at home, whereas the generalisation of exemption schemes in the EU would increase inward investment. We also highlight some externalities produced by tax changes in Europe on extra-European countries.

Turning to a comparison of tax harmonisation versus tax competition and dumping, the simulations highlight the potentially negative externality of tax competition in Europe for the foreign partners of the EU, namely the United States and Japan, who would lose from a non co-operative tax game in Europe.

Keywords : Tax competition, Tax harmonisation, Foreign direct investment, EMU.

JEL Classification : F21, H25, H87