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Journal of Economics and Finance

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12-06-2017

Reassessing the effects of bilateral tax treaties on US FDI activity

Authors: Abdullah Kumas, Daniel L. Millimet

Published in: Journal of Economics and Finance | Issue 3/2018

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Abstract

Despite substantial evidence that foreign direct investment (FDI) is influenced by taxation, the impact of bilateral tax treaties on FDI is surprisingly unclear. We provide a simple theoretical framework illustrating why the impact of tax treaties may be heterogeneous across the distribution of FDI, and thus why focusing on the average effect of tax treaties may be misleading. We then assess the empirical relevance of such heterogeneity by estimating the quantile treatment effects of tax treaties on US inbound and outbound FDI using panel data from 1980–1999. Our results are striking, and consistent with our expectations. We obtain positive effects of tax treaties at lower quantiles of the distribution of FDI, but negative effects in the upper quantiles. Moreover, while the negative effects are substantially larger in absolute terms relative to the positive effects, the two effects are roughly equivalent in percentage terms.

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Foreign affiliate sales (FAS) grew by 11% in the 1990s, roughly double the growth rate for exports and quadruple the growth rate for worldwide GDP (Markusen 2002). In 2004, total FAS represented nearly 51% of world GDP, with world exports representing roughly half this amount (Ramondo 2007).

Results from log specifications with country fixed effects yield positive, but insignificant results (Blonigen and Davies 2004). Mutti and Grubert (2004) also advocate the use of log-linear models when analyzing FDI.

A related literature assessing the impact of bilateral investment treaties (BITs) also fails to produce a consensus. For example, while Hallward-Driemeier (2003) fail to find a positive effect of such treaties on FDI, Egger and Pfaffermayr (2004) and Stein and Daude (2007) do.

Available at http://unpan1.un.org/intradoc/groups/public/documents/un/unpan004467.pdf.

An additional complication in theoretically assessing the effects of bilateral tax treaties is that while a reduction (increase) in the marginal effective tax rate abroad may increase (decrease) FDI activity, this direct effect may be partially or entirely offset by a corresponding reduction (expansion) in public infrastructure financed by tax revenues on MNEs. In fact, if the effect of public infrastructure on MNE costs is sufficiently strong, then a reduction (increase) in effective tax rates abroad may actually lead to a reduction (increase) in FDI activity (Egger et al. 2006).

Specifically, the objective of the host government is not to maximize national income (as in, for example, Janeba (1995) and Davies (2003b)), but rather to maximize the weighted sum of political contributions and social welfare. In Cole et al. (2006), political contributions are offered by MNEs to the host government in return for a more favorable (lax) environmental policy.

Other arguments for a declining effective tax rate exist at the firm-level. In a more complex model with multiple investors, the average marginal effective tax rate, conditional on aggregate capital investment, may be increasing in the number of investors (or, stated differently, decreasing in average investor size). For example, Grubert (2003) finds that the effective tax rate faced abroad by subsidiaries of US MNEs is declining in the size of the parent firm. Thus, a more realistic assumption may be that the average marginal effective tax rate is declining in aggregate capital flows conditional on the average investment size.

In practice, effective tax rates are rarely coordinated under tax treaties, and withholding taxes are set below the non-treaty withholding tax rates in both contracting countries. However, effective tax rates may still rise. For instance, Egger et al. (2006), using OECD data, find evidence consistent with parent countries using bilateral tax treaties to reduce the attractiveness of low-tax countries to MNEs. We return to this below.

Chisik and Davies (2004) analyze the outcome of the bargaining process when a bilateral tax treaty is entered using data from the US and OECD countries in 1992. The authors find that greater asymmetry between countries in terms of the level of FDI activity leads to higher negotiated tax rates.

If the marginal effective tax rates in both countries under the treaty is \( \overset{\sim }{t} \) < t, t* (due to a movement away from distortionary taxation with a treaty) or \( \overset{\sim }{t} \)> t, t* (due to a reduction in tax competition or excessive tax evasion with a treaty), then the preceding results are unaltered. For example, if \( \overset{\sim }{t} \) < t < t*, then the tax treaty entails a larger decline in the marginal effective tax rate in the host country. As a result, the impact of the tax treaty on host investment will remain positive when t < t* (i.e., Ƭ (x, x*) > 0).

As discussed below in Section 4, FDI activity may either be measured in terms inbound FDI from country j to country i, or outbound FDI from country i to country j. In addition, following Blonigen and Davies (2004), we focus compare FDI activity with and without a tax treaty in effect, as opposed to a tax treaty being signed or in force.

If the failure of the Ramsey specification test in Blonigen and Davies (2004) is due to omitted variables, then such omitted variables will in all likelihood also invalidate the QTE estimates based on the CIA. However, if the failure is simply due to a mis-specified functional form, then the QTE estimates are likely to remain consistent, although we do have to choose a function form for the first-stage probit model.

In the estimation, 500 equally spaced points are used.

The data are found at http://www.uoregon.edu/-bruceb/. We are very grateful to the authors for making the data available.

The number of country and year dummies varies by specification, as we can only include dummy variables for countries and years that are observed both with and without an effective treaty during the sample. Additional dummies violate the common support assumption (QTE.ii).

For example, using FDI stocks, the maximum (minimum) QTE is 4 (−2320), occurring at the 43rd (99th) quantile. For FAS, the maximum (minimum) QTE is 246 (−6398), occurring at the 97th (99th) quantile.

For example, using FDI stocks, the maximum (minimum) QTE is 4.3 (−3.6), occurring at the 39th (84th) quantile. For FDI flows, the maximum (minimum) QTE is 2.5 (−4.1), occurring at the 58th (89th) quantile.

For example, using FDI stocks in levels, the maximum (minimum) QTE is 776 (−25,000), occurring at the 3rd (99th) quantile. For FAS in levels, the maximum (minimum) QTE is 1835 (−20,200), occurring at the 7th (99th) quantile. Using FDI stocks in logs, the maximum (minimum) QTE is 7.6 (−1.5), occurring at the 2nd (82nd) quantile. For FAS in logs, the maximum (minimum) QTE is 9.9 (−1.7), occurring at the 7th (78th) quantile.

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Title: Reassessing the effects of bilateral tax treaties on US FDI activity
Authors: Abdullah Kumas
Daniel L. Millimet
Publication date: 12-06-2017
Publisher: Springer US
Published in: Journal of Economics and Finance / Issue 3/2018
Print ISSN: 1055-0925
Electronic ISSN: 1938-9744
DOI: https://doi.org/10.1007/s12197-017-9400-3

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