Tax effects on FDI – just a rerouting

Abstract

This paper investigates tax-related determinants of indirect foreign direct investment (FDI). In particular, it studies the effects of bilateral effective average tax rates, the strength of anti-tax avoidance rules in host countries, and tax haven status of home countries on the volume of indirect FDI host countries receive. The paper uses the fourth edition of the OECD Benchmark Definition of Foreign Direct Investment (BMD4) database, which distinguishes between ultimate and immediate FDI. Methodologically, the paper relies on the standard gravity equation for FDI and applies the Poisson pseudo-maximum likelihood estimation model. The paper shows that ultimate FDI is not influenced by tax-related factors but only real economic determinants, whereas tax rates affect immediate FDI. This finding suggests that previous research may have overestimated the tax elasticity of FDI, and taxes do not have an impact on location decisions of FDI, but rather the route of investing – direct or indirect. The paper defines indirect FDI as the difference between ultimate and immediate FDI and finds that high bilateral effective average tax rates encourage indirect FDI. The finding is robust under different specifications. Strong anti-tax avoidance rules decrease indirect FDI. Investors use mainly tax havens as conduit countries. Distance is another important determinant in the choice of indirect FDI structures.

Keywords: indirect FDI, bilateral effective average tax rate, anti-tax avoidance rule, tax haven

JEL Classification: F21, H26, C23