Foreign direct investment, legal uncertainty and corporate income taxation

Abstract

This paper asks whether legal uncertainty surrounding corporate income taxation can defer foreign direct investment (FDI) in developing economies. Legal risk or uncertainty can take many forms. We will focus on uncertainty circling around double tax agreements, differences in the type of legal systems and corruption. We test the effect of legal uncertainty on foreign direct investment both directly or indirectly thru taxation in an extended gravity model. Our unit of observation are country pairs (FDI sender and FDI receiver). We find that an increase in the ratio of the statutory corporate income tax rate of the destination relative to the source country exhibits a negative impact on foreign direct investment. Interacting the statutory corporate income tax rate with measures of legal uncertainty, we observe a negative effect. This implies that legal uncertainty detracts foreign direct investment, and the more so the higher are corporate tax rates.