Question

China is one of the most popular investment destinations in the world. Throughout much of the 1990s, China accounted for 50% of foreign direct investment (FDI) going into developing countries and between 1994 and 1997, China was the second largest recipient of FDI in the world, after the United States. Do you think the recent corporate tax cuts in the U.S. and the changes in tariff rates in both countries could affect FDI in China? Why? How? What about the FDI in the U.S.?

Answer 1

Recent analysis supports the view that the sensitivity of FDI to tax depends
on the host country and the mobility of business activities underlying the
tax base. In particular, where firms benefit from locating production in large
markets to reduce the costs of trade, such as transportation costs, a certain
degree of inertia is predicted in the location choice of firms. Host country
benefits and some fixity of capital mean that profits may be taxed up to some
point without discouraging investment. This view is consistent with the
observation that a number of OECD economies with large domestic output
markets and strong FDI inflows (e.g. US, Japan and Germany) have relatively
high corporate tax rates (see Figure 1). New explanatory models also suggest
that the optimal tax rate on business falls as trade costs fall and capital is
more mobile. This view is consistent with the observation that a number of
countries impose a lower tax burden on more mobile business activities such
as shipping, film production or head-office activities. ■
Most studies of the effects of tax reform on FDI ignore tax-planning strategies
used by investors to lower their tax burden. But tax planning activities seem
to be significant and growing, and recent OECD work encourages analysts to
factor in the effects of tax planning activities when analyzing the impact of
taxation on FDI (see Box 1). Future work in this area might lead to improved
estimates of the tax burden on FDI and of the tax sensitivity of FDI. ■
Tax competition for FDI is a reality in today’s global environment. Investors
routinely compare tax burdens in different locations, as do policy makers,
with comparisons typically made across countries that are similar in terms of
location and market size. A widely-held view is that taxes are likely to matter
more in choosing an investment location as non-tax barriers are removed and
as national economies converge.
There is broad recognition that international tax competition is increasing,
and that what may have been regarded as a competitive tax burden on
business in a given host country at one point in time may no longer be so
after rounds of tax rate reductions in other countries.
However, it is not always clear that a tax reduction is required (or is able)
to attract FDI. Where a higher corporate tax burden is matched by well-
developed infrastructure, public services and other host country attributes
attractive to business, including market size, tax competition from relatively
low-tax countries not offering similar advantages may not seriously affect
location choice. Indeed, a number of large OECD countries with relatively high
effective tax rates are very successful in attracting FDI. This points to the
importance of market size and other host country attributes in attracting FDI
and the presence of location-specific profits that governments are able to tax.
It is also clear that a low tax burden cannot compensate for a generally
weak or unattractive FDI environment. Tax is but one element and cannot
compensate for poor infrastructure, limited access to markets, or other weak
investment conditions. Also, while attention often focuses on corporate
income tax, the importance of other taxes must be recognised.