Working Paper: CEPR ID: DP5511
Authors: Assaf Razin; Efraim Sadka
Abstract: This paper brings out the special mechanism through which taxes influence bilateral FDI, when investment decisions are two-fold in the presence of fixed setup flows costs. For each pair of source-host countries, there is a set of factors determining whether aggregate FDI flows will occur at all, and a different set of factors determining the volume of FDI flows (provided that they occur). We develop a two-country tax competition model which yield an asymmetric Nash-equilibrium with high corporate tax rate and high level of public good provision in the rich source country for FDI outflows and with low corporate tax rate and low level of public good provision in the poor host country for FDI inflows. This is akin to the asymmetry among the EU 15 and EU 10 in the enlarged European Union, as of 2004. We also demonstrate that the notion that the mere international tax differentials are a key factor behind the direction and magnitude of FDI flows, the traditional race to the bottom argument in tax competition are too simple.
Keywords: Enlarged European Union; Source-Host Country; Foreign Direct Investment; Tax Competition
JEL Codes: F15; F21; H3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| source country tax rate (H87) | decision to invest (G11) |
| host country tax rate (F38) | flow of FDI (F21) |
| decision to invest (G11) | FDI flows (F21) |
| source country tax rate (H87) | flow of FDI (F21) |
| host country tax rate (F38) | decision to invest (G11) |