and average tax rates (EAT R) as published in Devereux, Griffith, and Klemm
(2002), indicate a significant role of tax differentials for foreign plant location.
Razin, Rubinstein, and Sadka (2005) point out that statutory tax rates affect
FDI flows in two ways. First, they determine whether it is profitable for any
firm to invest in a particular host country at all (sample selection). Second,
given that some investment takes place, they affect the magnitude of these in-
vestments. Razin, Rubinstein, and Sadka (2005) find supportive evidence for
these hypotheses in a panel of bilateral OECD FDI flows. Regarding invest-
ment flows to Central and Eastern European countries, Carstensen and Toubal
(2004) observe a significant negative impact of the difference in host and parent
country statutory corporate tax rates on inward FDI.4
Overall, previous empirical research is characterized by two features. First,
most of the existing literature considers the parent and/or host country tax
rate or composite measures of tax burden (e.g., forward- or backward-looking
effective tax rates). The former approach ignores important tax-related deter-
minants of FDI, such as depreciation allowances or host country withholding
taxes (see Clark, 2000; OECD, 2001). The problem with the latter approach is
that it is difficult to draw strong conclusions about the ’composite’ impact of
the tax components through effective tax rates on MNE activity.5 In particular,
our theoretical hypotheses shed light on the fact that some of the components
of effective tax rates exert a non-monotonic effect on FDI, where the sign of
the impact depends on the relative prevalence of multinational versus national
firms.
Second, many of the existing applications tend to rely on an eclectic ap-
proach to specifying empirical FDI equations. In this regard, Hines (1999, p.
311) emphasizes that
”[O]ne of the difficulties facing all cross-sectional studies of FDI lo-
cation is the inevitable omission of many important determinants of
FDI that may be correlated with tax rates and therefore bias estima-
tion of tax elasticities.”
4De Mooij and Ederveen (2003), performing a meta-analysis based on 25 empirical studies
on FDI and taxation, estimate a (median) tax rate elasticity of -3.3. Focusing on U.S. studies,
Hines (1997) reports a tax rate elasticity of approximately -0.6.
5Basically, effective tax rates are an aggregate measure of company tax burden, i.e., the
same level of the effective tax rate may be a result of different combinations of its components.
Hence, an increase of effective tax rates may be due to entirely different changes in the
underlying components. More importantly, it can be shown that in a general equilibrium
model of trade and multinationals as the one applied below, effective (marginal and average)
tax rates change across endowment configurations, even if the tax parameters themselves
remain unchanged. Hence, effective tax rates are endogenous even for given tax rates.