- Productivity and Taxes as Drivers of Foreign Direct Investment
Foreign direct investment (FDI) is a form of international capital flows. It plays an important role in the general allocation of world capital across countries. It is often portrayed, together with other forms of capital flows, as shifting capital from rich, capital-abundant economies to poor, capital-scarce economies, as a means to close the gap between the rates of return to capital and enhance the efficiency of the worldwide stock of capital. This general portrayal of international capital flows may indeed pertain to FDI flows from developed countries to developing countries, which are almost all net recipients of FDI. However, this portrayal of international capital flows is hardly reminiscent of the FDI flows among developed countries, which are much larger than those from developed to developing countries. Although net aggregate FDI flows from, or to, a developed country are typically small, the gross flows are quite large.
In this paper we indeed focus on bilateral FDI flows among member countries of the Organization for Economic Cooperation and Development (OECD). We study the effects of two sets of driving forces that affect FDI: productivity and taxation. Specifically, we attempt to shed some light on some key mechanisms through which these sets affect FDI flows.1 An important feature of our FDI model (which distinguishes FDI flows from portfolio flows) is fixed setup costs of new investments. This introduces two margins of FDI decisions: an intensive margin of determining the magnitude of the flows of FDI, according [End Page 105] productivity conditions, and also an extensive margin of determining whether to make a new investment at all. Productivity and taxes may affect these two margins in different, possibly conflicting, and crucial ways. The magnitude of the setup costs can well be industry-specific, thereby giving rise to two-way rich-rich, as well as rich-poor, FDI flows.
Also, threshold barriers play an important role in determining the extent of trade-based foreign direct investment.2 The trade-based literature typically focuses on issues such as the interdependence of FDI and trade in goods and the ensuing industrial structure. For instance, studies have attempted to explain how a source country can export both FDI and goods to the same host country. The explanation essentially rests on productivity heterogeneity within the source country and on differences in setup costs associated with FDI and export of goods. The trade-based literature on FDI is based on a framework of heterogeneous firms.3 Thus the empirical approach in this trade-based literature focuses on firm-level decisions on exports and FDI in the source country, using microdatasets. Our approach is to analyze aggregate bilateral FDI using countrywide datasets. Note that micro–cross-country panel datasets are not available, so that micro-based empirical studies typically have to be confined to a single source or host country and to extremely short time spans. In contrast, we have data for nineteen OECD countries over a large interval of time (1987–2003).
We first study the role of source country and host country productivities on the twofold FDI decisions. Specifically, we develop a framework in which the host productivity has a positive effect on the intensive margin (the size of FDI flows), but an ambiguous effect on the extensive margin (the likelihood of FDI flows to occur). The source productivity has a negative effect on the extensive margin. These predictions are tested in the data. We then study the effects of corporate taxation on FDI. Earlier studies have suggested that FDI is sensitive to tax rate differences.4 Our contribution to this discussion is that the tax rates of the host and source countries may have differential effects on the two margins of FDI decisions. Therefore, the sensitivity of FDI to tax rate differentials may be blurred.5
The organization of the paper is as follows. The next section presents an analytical framework with productivity as a driving force of FDI. The third section [End Page 106] extends this framework to include corporate taxation as an additional driving force. The fourth section describes our econometric approach. The fifth section describes the data, followed...