Corporate tax effects on the quality and quantity of FDI

Abstract

This paper measures the relative importance of quality and quantity effects of corporate taxation on foreign direct investment. Quantity is affected if corporate taxes reduce the equilibrium stock of foreign capital in a given country. Quality effects arise if taxes decrease the extent to which investment contributes to the corporate tax base and the capital intensity of production. Depending on the sign of the quality effects, the detrimental welfare effects of corporate taxation are either mitigated or aggravated. We derive a number of hypotheses about how corporate tax changes may affect the quality of investment. Our hypotheses are then tested using data from a large sample of European multinationals. With regard to corporate tax effects on the corporate tax base, we find that quality effects account for up to 40% of the total effect. With regard to corporate tax effects on labour income, our results suggest that quality effects mitigate the negative quantity effect by nearly 60% (as corporate taxes strongly increase the labour intensity of production). An important implication is that governments should not exclusively care about the size of inbound FDI flows but also about their specific characteristics, i.e. their quality.