1 Introduction
What are the expected effects of parent and host country parameters of taxation
(statutory corporate and withholding tax rates, and the definition of the tax
base) on bilateral multinational activity in general equilibrium under alternative
methods of double taxation relief? What is their impact on bilateral stocks of
foreign direct investment (FDI) in an empirical application? These issues are of
obvious importance to policy makers. Yet, existing research does not provide an
encompassing answer to these questions, as will be illustrated in detail below.
The importance of relying on general equilibrium models to derive the hy-
potheses regarding the impact of taxation on FDI has been pointed out by
Hines (1997, p. 418):
”In the absence of a complete general equilibrium model, it is impos-
sible to predict with certainty the impact of tax changes on capital
demand throughout a multinational firm.”
This paper analyzes the relationship between taxation and FDI in a
knowledge-capital general equilibrium model of multinational enterprises
(MNEs; see Markusen, 1997, 2002). This framework seems especially suited
for studying the role of corporate taxation on FDI, since it has become the
workhorse model of numerous recent empirical studies on the determinants
of bilateral multinational activity (e.g., Carr, Markusen, and Maskus, 2001;
Markusen and Maskus, 2002; Blonigen, Davies, and Head, 2003; Braconier,
Norback, and Urban, 2005). Controlling for the most important endowment-
related and trade and investment impediment-related determinants of FDI, we
analyze the role of parent and host country parameters of taxation under alter-
native methods of double taxation relief. The model enables us to predict the
sign of the effect of an increase in each parameter of taxation on multinational
activity, separately. One particular advantage of this general equilibrium model
is that taxation does not only affect the extent of multinational activity (as,
e.g., in Devereux and Hubbard, 2003, and in Devereux and Lockwood, 2006),
but even the configuration of plants and the integration strategies of firms in
equilibrium.
Based on the insights of the theoretical model we use parent and host statu-
tory country corporate tax rates, withholding tax rates, (net present values of)
parent and host country depreciation allowances, and information about the
underlying method of double taxation relief (i.e., credit, exemption, and deduc-
tion) in the empirical exercise. We collect annual data from national tax codes