Why Tax Incentives May be an Ineffective Tool to Encouraging Investment? – The Role of Investment Climate

Abstract

In this paper we first analyze theoretically how the investment climate affects the impact of the corporate tax rate on investment. We do so in a model where the tax revenues are used to improve the investment climate. We find that if the investment climate is very effective at enhancing the productivity of capital, capital can react positively to a rise of the tax rate. However, this result is only true if a higher tax rate yields extra tax revenues. We also determine the conditions under which an improvement of the investment climate increases the opposition of capital to a rise in the tax rate. This is only the case if the investment climate is very complementary to capital or if the complementarity of the investment climate is much higher at low levels of the investment climate than at high levels of the investment climate. In the end, whether an improved investment climate increases or decreases the opposition of capital to a rise in the tax rate is an empirical question.

We test the model using a cross section of 80 countries ranging from very bad to very good investment climate countries. With FDI as a percentage of GDP as the dependent variable, a unique series of Marginal Effective Tax Rates as the tax variable and several investment climate variables are used to find two important results. First, an improvement of the investment climate increases the opposition of capital to a rise in the tax rate. Second, in the worst investment climate countries capital reacts not negatively to a rise in the tax rate.

These results lead to the important policy implication that for bad investment climate countries it is ineffective to lower the tax rate to compensate for the bad investment climate. Instead, they should focus on improving the basic investment climate.

Keywords: Tax Incentives, Investment Climate, METR, Tax Policy, Corporate Tax

JEL Classification: E62, H25, H32