Corporate Taxation and Multinational Activity



foreign affiliate production.15 The reason for the positive nexus of parent coun-
try tax rates and outbound MNE activity is that the change in its tax rate only
affects domestic production. For similar reasons, a higher tax rate in the host
country reduces affiliate production there. Hence, the predicted effect of an
increase in parent (host) country corporate tax rates on a country’s outbound
MNE activity is positive (negative) under exemption.

With the credit method, the effects of corporate tax rates are ambiguous if
horizontal MNE activity prevails (i.e., the factor endowment differences are not
important; see the first three endowment configurations under tax credits in
Table 1). As becomes apparent from (16), the impact of a tax increase depends
on the differential between domestic and foreign corporate tax rates. If the
parent country is in an excess credit position (i.e., its corporate tax rate is
lower than the host country tax burden; see footnote
c in Table 1) the effect of
the parent country’s tax increase is the same as under the exemption method.
An increase in the statutory tax rate of the parent country fosters its foreign
affiliate production. The tax increase, by contrast, applies to operating profits
of foreign affiliates if the parent tax rate is equal to or higher than the host
tax burden. This reduces foreign affiliate activities of horizontal MNEs, while
rendering the domestic production of host country owned firms better off.
16 For
similar reasons, an increase in the host country’s corporate tax rate induces the
opposite effect.

With a deduction system, an increase in the corporate tax rate reduces MNE
activities in both countries,
17 with two exceptions. First, if both countries
are identical, an increase in the host country corporate tax rate fosters foreign
affiliate activity there, as long as the tax burden becomes not prohibitively high.
Although the tax burden is increased for all (domestic and foreign) MNEs, the
foreign ones are even more exposed to double taxation. Second, for skilled labor
abundant parent countries, an increase in the parent country’s corporate tax
15 Slemrod (1990) was the first who has pointed to a positive relationship between the parent
country tax rate and outbound FDI, especially under the exemption system. In this regard,
Hartman (1990, p. 121) criticized that ”... the sign of the home country taxation parameter
is indeterminate from economic theory.” According to the insights from our model, Slemrod
rightfully suggested using parent country corporate tax rates as a determinant of outbound
FDI.

16In the case of identical factor endowments, the impact of a parent country’s tax increase
on foreign affiliate activity is only positive if both countries are in an excess credit position,
i.e., (
tj - tiw (1 - ti)) < ti < (tj + tjw (1 - tj)), obtaining the same result as with the exemption
method.

17As discussed above, the deduction method leads to zero MNE activity for a small country.
For such a situation, we are not able to identify a change in MNE activity due to an increase
in the tax parameters. However, to illustrate the impact of tax changes we re-parameterize
the model such that MNE activity arises in the initial equilibrium (see footnote
b in Table 1).

17



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