Corporate taxation has implications for international investment allocation. From the global minimum tax debate to the argument for more inclusive economic systems, tax competition remains one of the most important credos of orthodox macroeconomic policy. As the ongoing accelerated pace of digitisation continues, the subject of international mobility of productive capital is back on the front burner of policymaking in many jurisdictions interested in attracting foreign direct investment (FDI).
Insofar as the location choices of potential investors are driven by varying degrees of institutional quality and corporate tax rates, governance infrastructure will continue to be critical vis-à-vis the sensitivity of FDI inflows to host country tax rates.
FDI flows and the global North-South divide
The debate gets even more interesting when viewed through a global North-South lens. The issue of asymmetries in the impact of corporate tax differentials on FDI between developed and developing countries features prominently in economic development policy and practice. In the advanced industrial nations, governance infrastructure – via stable and transparent regulatory and policy regimes – is generally conducive to FDI inflows. However, due to a wide range of political economy factors, the effect of the institutional dimensions of governance on inward FDI is more nuanced in developing countries – partly because this could present a ‘double whammy’ whereby lower tax rates do not significantly increase foreign investment, while higher rates deter new capital inflows.
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The welfare effects of FDI competition
How effective are tax incentives as investment attraction tools? From subsidies and tax benefits to financial incentives and other perks used to mitigate actual or perceived risks that may serve as deterrents to capital inflows, tax incentives are popular FDI attraction tools worldwide. While subsidising FDI is a popular economic development paradigm, the overall welfare effect on host regions remains highly contentious. This becomes even more complicated when such competition becomes a ‘race to the bottom‘.
To be clear, there are many benefits associated with the use of incentives for attracting FDI, but the core argument against this practice is based on the often sizeable revenue losses from incentives-based competition for capital inflows. Apart from potential under-provision of public goods, distortions in the location decisions of companies could also create unintended consequences.
In a survey of 750 multinational investors and corporate executives, the World Bank concludes that political stability, security and legal and regulatory environment are more important than low tax rates and labour costs in deciding to invest in developing countries (see chart below).
The chart shows that in scenarios where the choice of a host jurisdiction is not dependent on specific locational advantages but driven largely by access to specific natural resources or domestic markets, FDI incentives become inconsequential. This has major implications.
Governance and investment competitiveness
In theory, jurisdictions with strong governance performance should witness economic progress and political stability, which, in turn, should make them attractive to inward FDI. However, at the regional level, demographic and market nuances often shape how economic and social structures interact to reinforce jurisdictional investment competitiveness.
Not only does this underscore the role of the transmission mechanism through which governance impacts the ability of jurisdictions to attract capital, it also explains why the outcomes of the interactions across and within jurisdictions and industry sectors matter in the investment attraction business.
The real costs of tax incentives matter
The real costs of tax incentives are not always obvious, since such costs may include the distortion and deadweight loss resulting from the rent-seeking activities of companies lobbying for incentives. As such, this underscores the importance of ensuring that policy designs maximise the marginal impact of financial incentives.
To help shift attention away from redundant fiscal incentives that not only generate welfare loss by limiting the resources available for essential public services but also impact domestic resource mobilisation capacity, policymakers need a nuanced understanding of how different factors drive location decisions.
To conclude, while inducements are useful – under specific circumstances – they are not a substitute for industrial policy and investment measures that put governance improvements and the overall business environment front and centre.
Dr Fred Olayele is a senior partner with the Economic Innovation Practice Group, a boutique economic development advisory firm. He has published extensively on trade policy, innovation, FDI and inclusive development. An economist, professor, and public policy executive, he has consulted widely and advised many public, private and development institutions in Canada, the US and internationally.