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Why Lower Tax Rates May be Ineffective to Encourage Investment: The Role of The Investment Climate

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  • S. VAN PARYS
  • S. JAMES

Abstract

In this paper we first analyze theoretically how the investment climate can affect the impact of corporate taxation on investment in a simple tax competition model where the corporate tax revenues are used to improve the investment climate. We find that an improvement of the investment climate increases the sensitivity of capital to the tax rate if the investment climate is very effective at enhancing the productivity of capital or if the investment climate enhances the productivity of capital much more when the initial investment climate is unattractive than when the initial investment climate is already attractive. As a result, the model calls for the estimation of an investment equation where the tax variable is moderated by an investment climate variable. We estimate such an investment equation using a unique panel dataset of effective corporate tax rates of 80 countries, including countries with an unattractive and countries with an attractive investment climate, for the period 2005-2008. We find two important results. First, a better investment climate increases the sensitivity of FDI to the tax rate. Second, in the worst investment climate countries, FDI reacts not negatively to a rise in the tax rate. These results have important policy implications. For bad investment climate countries it is ineffective to lower the tax rate to compensate for the bad investment climate. Instead, these countries should focus on improving the basic investment climate.

Suggested Citation

  • S. Van Parys & S. James, 2010. "Why Lower Tax Rates May be Ineffective to Encourage Investment: The Role of The Investment Climate," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 10/676, Ghent University, Faculty of Economics and Business Administration.
    • Handle: RePEc:rug:rugwps:10/676
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    References listed on IDEAS

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    1. Ruud A. de Mooij & Sjef Ederveen, 2008. "Corporate tax elasticities: a reader's guide to empirical findings," Oxford Review of Economic Policy, Oxford University Press and Oxford Review of Economic Policy Limited, vol. 24(4), pages 680-697, winter.
    2. de Mooij, Ruud A & Ederveen, Sjef, 2003. "Taxation and Foreign Direct Investment: A Synthesis of Empirical Research," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 10(6), pages 673-693, November.
    3. Stefan Parys & Sebastian James, 2010. "The effectiveness of tax incentives in attracting investment: panel data evidence from the CFA Franc zone," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 17(4), pages 400-429, August.
    4. Agnès Bénassy-Quéré & Nicolas Gobalraja & Alain Trannoy, 2007. "Tax and public input competition [‘Tax competition and economic geography’]," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 22(50), pages 386-430.
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    Cited by:

    1. Dorota Wawrzyniak, 2013. "Opodatkowanie przedsiębiorstw jako determinanta bezpośrednich inwestycji zagranicznych w krajach Unii Europejskiej," Gospodarka Narodowa. The Polish Journal of Economics, Warsaw School of Economics, issue 3, pages 37-55.

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    Keywords

    tax competition; investment climate; developing countries; Foreign Direct Investment; corporate tax;
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