Do Taxes Matter for Foreign Direct Investment?

Abstract

The tax sensitivity offoreign direct investment (FDI) has important policy implications. If FDI is not responsive to taxation, then it may be an appropriate target for taxation by the host country. This question is examined for Mexico by estimating the response of FDifrom retained earnings and transfers from abroad to the tax regimes in Mexico and the home country, the credit status of multinationals, country risk factors, and regulatory and trade regimes in Mexico. FDi in Mexico is found to be sensitive to the tax regimes in Mexico and the United States, the credit status of multinationals, country credit ratings, and the regulatory environment. Thus Mexico's current policies to dismantle regulations and employ a tax system competitive with the United States are expected to have salutory effects on FDI in Mexico. The 1980s have seen a remarkable growth in foreign direct investment (FDI), which has sparked a renewed interest in the effect of FDI on the economic performance of both the host and the home country and in the appropriate government policy toward FDI. Not surprisingly, a critical consideration in this discussion is the responsiveness of FDI to taxation of the income that it generates. If FDI iS not responsive to taxation, then it may be an appropriate target for taxation by the host country, which can raise revenue without sacrificing the economic benefits of FDI. If, however, the volume of FDI declines with taxation, the host country must consider the trade-off between the possible revenue gains from increased taxation and the economic costs of discouraging FDI. This issue is very important for countries in which the degree of FDI penetration is large and the revenue raised from taxing FDI represents a significant fraction of total tax revenue. For example, in Ecuador, Egypt, Indonesia, Nigeria, Peru, and Trinidad and Tobago tax payments by U.S. corporations alone as a share of host country corporate tax revenues exceed 10 percent (Alworth 1988, p. 33). Because of the ready availability of data on investment to and from the United States, most of the recent empirical literature on the tax sensitivity of FDI has focused on U.S. inward FDI. In this article we extend the standard methodology used in these studies to examine the effect of taxation on FDI in Mexico. The recent empirical literature on FDI in the U.S. is reviewed. The salient features of