Introduction
There is a substantial body of evidence showing that effective corporation tax rates
and the general tax landscape have a strong influence on the level of foreign direct
investment (FDI) that a location can attract and on financing decisions associated with
these investments.1 In an early review of the empirical literature, Hines (1999)
concludes that the evidence indicates that “taxation significantly influences the
location of foreign direct investment, corporate borrowing, transfer pricing, dividend
and royalty payments, and R&D performance.”
Work done since then has confirmed and strengthened these findings. Desai, Foley
and Hines (2003) use affiliate-level data for US companies investing abroad between
1982 and 1997 to examine the relationship between effective corporation tax rates and
investments by foreign-affiliate companies. They find a strong negative effect, with
an elasticity of around -0.5. Allowing for elasticities to differ by host country/region,
they find that tax effects are particularly strong in Europe, for which an elasticity of -
0.77 is found. The work of Altshuler et al. (2001) suggests that the relevant elasticity
has been growing over time.
Grubert and Mutti (2000) and Slaughter (2003) also concentrate on the location
decisions of US firms, while Gropp and Kostial (2000) present evidence on total FDI
inflows and outflows.2 The evidence is unequivocal that in circumstances where
other locational factors - such as the existence of a pool of well qualified labour,
reasonable infrastructure, business-friendly and robust political structures and
membership of wider economic unions such as the EU - are similar, a lower rate of
corporate tax can serve as a powerful tool to attract mobile international capital.
Tax policy also affects the financing decisions of Multinational Corporations. For
example, if a US company investing abroad finances the investment with equity, its
active profits in this case are taxable in the host country but free from tax in the US
until repatriated. Financing the investment through a loan from the parent company,
on the other hand, gives rise to tax-deductible interest payments in the host country
and taxable interest receipts in the US. Thus there is an incentive to finance
investments in high tax countries through debt and in low tax countries through equity.
The empirical evidence is consistent with this hypothesis (Grubert 1998, 2000).
These financial considerations can greatly influence the amount of tax paid in a low-
tax host country independent of the actual activity carried out there. To satisfy taxing
authorities in the donor country, however, some evidence of real activity in the host
country is typically required.
Transfer pricing, though strictly policed, is thought to allow some scope for firms to
shift profits to low-tax locations by setting favourable intra-group trade prices. As
Desai, Foley and Hines (2006) point out, “OECD governments require firms to use
transfer prices that would be paid by unrelated parties, but enforcement is difficult,
particularly when pricing issues concern differentiated or proprietary items such as
1 The effective tax rate is calculated by combining tax rates, which have been declining in most
industrialised countries over recent decades, and the tax base, which has generally widened. The
literature also distinguishes between effective average and effective marginal tax rates; see e.g.
Devereux, Griffith and Klemm (2002).
2 Devereaux and Griffith (2002) present a survey of other work on the topic.