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Home > Business Strategy Viewpoints > Corporate Taxation and Its Impact on Foreign Direct Investment

Business Strategy Viewpoints

Corporate Taxation and Its Impact on Foreign Direct Investment

by Graeme Leach

Introduction

Graeme Leach is Chief Economist and Director of Policy at the Institute of Directors, which he joined in August 1998. He is also visiting professor of economic policy at the University of Lincoln.

A frequent conference speaker and media commentator on the UK and global economy, in recent years he has spoken at conferences in the US, Canada, China, Germany, Italy, France, Spain, Sweden, Ireland, Belgium, Greece, Taiwan, and Zimbabwe.

In 2006 he was appointed to the Conservative Party’s Commission for Tax reform.

Prior to joining the IoD he was economics director at the Henley Centre, analyzing future economic and social change. This included editorship of The Henley Centre’s UK economic forecasts, global macroeconomic outlook and consumer and leisure futures services. As part of this consulting, he has recently produced Tomorrow’s Work, a Report Into the Future of the Way We Work, and is currently researching for a forthcoming book entitled The Future of the West.

In 1998 he was awarded the WPP Atticus Award for original published thinking on futures issues.

Previously, Graeme worked as economic adviser to the Scottish Provident Investment Group, and as a senior economic consultant with Pieda.

Taxation and FDI

The burden of corporate taxation obviously influences the volume and location of foreign direct investment (FDI) for the simple reason that it determines after tax returns from investment. In a globalize world economy with footloose investment, multinational enterprises have the capacity to shift their location and/or taxable income across borders. There is also an asymmetry to the impact of taxation and FDI. Small differences in the tax burden may have little or no impact on FDI as the location decision is based on a number of factors and a small discrepancy in one area is unlikely to swing the location decision. In contrast, a large divide in the tax burden can become the tipping point issue, elbowing aside other influences. Even where a country had a significant advantage in tax competitiveness, which has then eroded, it may still lead to relocations. An example of this would be where a country was traditionally weak say in the competitiveness of its transport and education systems, but had enjoyed a real competitive advantage in its tax system. If the tax advantage falls, even when remaining positive, it could highlight deficiencies in other areas and thereby trigger a relocation elsewhere.

Consequently, a competitive corporate tax system is a necessary but not sufficient condition to attract FDI. Possessing a low tax burden and very little else will not attract FDI. Afghanistan has a zero rate of corporate income tax but is clearly not in receipt of massive private sector investment. The UAE, in comparison, also has a zero rate of corporate income tax which when combined with other influences has achieved huge inward FDI.

The Organisation for Economic Co-operation and Development (OECD) has recently stated that: “there is a 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.”

So what drives inward and outward FDI and what is the role of corporate taxation in this process? FDI, like competitiveness, is not determined by a single driver. Many factors intervene in this process, such as market size, market growth, proximity to market, access to market, labor supply, transport infrastructure and the quality of the physical infrastructure.

Taxation is but one of many influences on inbound FDI but how important is it in comparison to other primary influences? These are the issues to which we now turn.

Which Measure of Taxation Do Companies Look at?

When assessing the impact of corporate tax on FDI a very real obstacle emerges at the outset. When multinational companies look at an overseas investment how do they define the tax rate they are likely to pay?

Is it the headline rate of marginal tax or is it the average rate of corporate taxation? Does it include or exclude employer social insurance contributions? Or do companies think in terms of the effective rate of taxation based on an assessment of prospective reliefs and allowances for which they will be eligible? How significant is the burden of indirect, energy and environmental taxes? To what extent is the decision based on the complexity of the tax system and the resources required to achieve compliance? To what extent does consistent application of tax law—or lack of—influence overseas investors? To what extent is the decision made on the basis of personal rates of income tax?

There are also significant differences in terms of the relationship between different types of FDI (manufacturing, service sector, advanced economy versus emerging market) and the tax system. Another huge issue of course is the role of transfer pricing within multinational organizations and the scope it provides for evading or reducing tax liabilities.

Tax planning clearly matters but it is difficult to allow for all these influences in cross country comparisons. The relative importance of each factor will almost certainly differ depending on the nature of the FDI decision.

PricewaterhouseCoopers (PwC) publish annual data on corporate tax rate, labor tax rate and other tax rates in order to estimate a total tax rate (TTR). PwC place the UK 59th in the world based on its TTR ranking. The complexity of the analysis is well illustrated by France. France’s TTR ranks 160th in the world, below Zimbabwe at 156. Nobody would surely suggest this made Zimbabwe a better investment than France. A range of reliefs and allowances mean that France has a low effective rate of corporate tax, but very heavy payroll taxes result in a high overall TTR.

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