FDI Determination and Corporate Tax Competition in a Volatile World

This paper investigates the role of economic and political voltility in the process of corporate tax rate determination. Based on a theoretical framework that allows for the ability of multinational firms to choose the optimal timing of foreign investment and to shift profits by transfer pricing, the paper provides an empirical analysis on a large panel data set of countries over the 1983-2003 period. First, a reduced-form dynamic equation of corporate tax rate determination is estimated by generalized method of moments (GMM), where a country's top statutory corporate tax rate depends on a number of measures of economic and political volatility. Our results support the hypothesis that economic volatility is associated with lower top statutory corporate tax rates, while our measures of political volatility have no significant impact on corporate taxation policy. In order to identify the channels through which volatility works, we estimate a structural model allowing for simultaneous determination of the corporate tax rate and the inflow of FDIs to a country, and we are able to show that economic volatility affects the corporate tax setting process through its impact on FDI inflows.