model follows our theoretical framework and is also in line with recent empirical
research emphasizing parent and host country size, their skilled labor endow-
ments, trade and investment costs, and interaction terms thereof as the most
important determinants of MNE activity (Carr, Markusen, and Maskus, 2001;
Markusen and Maskus, 2002; Blonigen, Davies, and Head, 2003). Whereas most
of the estimated specifications employ dependent and independent variables in
levels, Mutti and Grubert (2004) find that a specification in logs is superior
from an econometric point of view.
Therefore, we specify the log of FDI stocks from country i to country j
in year t, F DIijt, as a log-linear function of the following explanatory vari-
ables. The sum of parent and host country GDP in period t, ΣGDPijt =
log GDPit + log GDPjt , the similarity between the parent and the host mar-
ket in country size, ∆GDPi2jt = (log GDPit - log GDPjt)2, and four inter-
action terms to account for the impact of knowledge-capital (skilled labor
endowment differences, ∆SKijt = log SKit - log SKjt) on FDI: INT 1ijt =
∆SKijt ×∆GDPijt ×I(∆SKijt > 0), where ∆GDPijt = (log GDPit-log GDPjt)
and I(∆SKijt > 0) is a dummy variable that is set to 1, if ∆SKijt > 0, and 0
else; INT 2ijt = ∆SKijt × ΣGDPijt × I(∆SKijt > 0); INT3ijt = -∆SKijt ×
ΣGDPijt × I(∆SKijt < 0), where I(∆SKijt < 0) is a dummy variable that is
set to 1, if ∆SKijt < 0, and 0 else; and INT 4ijt = ∆SKijt × log DISTij, where
DISTij is the great circle distance between the parent’s and the host’s capitals,
serving as a proxy for trade costs. According to the literature, horizontal FDI
is expected to rise, if the two economies become larger and more similar (i.e.,
ΣGDPijt rises and ∆GDPijt declines). Vertical FDI is expected to increase,
if the parent country becomes smaller and/or relatively better endowed with
skilled labor, especially, if the trade costs between the two countries are low.
Hence, we expect a positive sign for the parameters of ΣGDPijt and ∆GDPi2jt ,
but a negative one for the parameters of INT 1ijt, ..., INT4ijt.
In addition to the variables motivated by the original knowledge-capital
model, the above variant of it supports the use of the following components
of country-pair specific (bilateral) tax rates: the parent and the host country
statutory corporate tax rates (tit, tjt), whose impact depends on the prevailing
method of double taxation relief established in tax treaties (i.e., exemption,
credit, and deduction);19 the withholding tax rate applying to repatriated prof-
19 Note that for about 97 percent of the observations a tax treaty is effective. Of the remain-
ing three percent, about one percentage point (i.e., 18) of the observations are covered by the
European Union’s Parent-Subsidiary Directive (Directive 90/435) that applies to FDI within
the European Union. For the remaining two percent (i.e., 54) observations in our database,
methods of double taxation relief (exemption, credit, deduction) are applied unilaterally.
19