THE TAX AND INFLOW OF FDI

Transcription

1 Heri Bezić University of Rijeka, Faculty of Economics, Rijeka, Croatia Duško Pavlović College of Business and Management "Baltazar Adam Krčelić", Zaprešić, Croatia THE TAX AND INFLOW OF FDI Key words: FDI, multinational companies, corporate tax rate ABSTRACT The article examines the impact of corporate tax rates on inflow of foreign direct investments. In the last 15 years the countries all over the world have adopted numerous measures in order to attract more foreign capital. One of the most common measures has been the reduction in the corporate tax rates. Although useful article shows that taken in isolation this measure has not had a significant impact on investment decision taken by the foreign investors. Macroeconomic stability, stable social and political environment, ease of doing business and ability to hire skilled labour influence investment decisions much more then the level of corporate tax rates. Croatia has also louvered its corporate tax rate from 35% to 20% in Judging from the available data that has not had any impact on inflow of FDI. In order to attract more greenfield investment Croatia will have to sort out some domestic issues and to organise more effective targeting of the largest multinational companies. 1. INTRODUCTION Many countries all over the world engaged in the process of privatization and liberalization in the last two decades, enabling foreign investors to buy state companies in almost all industries. This process boosted the inflow of FDI to almost all parts of the world. FDI are not a new phenomenon. Investment activity of the largest companies outside national borders has been going on since 19 th century. What is new is the number of sectors in which the money is invested and the number of countries involved. The investments in 19 th and the first part of 20 th century, although significant, were mostly concentrated into large infrastructure projects and exploitation of mineral resources. Today, almost all sectors and almost all countries are involved. Acknowledging the importance that FDI could play in the economic development, countries have adopted different measures in order to encourage the inflow of foreign money. This article is the result of the scientific projects "Innovation, Technology Transfer and Competitiveness of Croatian Export" n o financed by Croatian Ministry of Science, Education and Sports 1 Electronic copy available at:

2 It took several decades and a lot of talk to persuade countries to lower tariffs on imported goods. As far as FDI are concerned that was not needed. The countries all over the world have been competing in offering the best possible conditions for foreign investors. The numerous measures have been adopted in order to make a host country more attractive for foreign investments. One of the most frequent was reduction in taxes, especially in corporate tax rate. The main thesis of this study is that reduction in taxes, taken as an isolated measure, does not influence the inflow of FDI. After introduction, the section two of this paper examines the value, the sources and the trends in flow of FDI in the last fifteen years. The third section shows the scale of reduction in corporate tax rates and examines the importance that it had on inflow of FDI to a particular country. The Republic of Croatia has followed the worldwide trend and has adopted numerous measures to attract foreign investors. These measures and the effect that they had on inflow of foreign money to Croatia are analyzed in section four, and the fifth section is conclusion. 2. THE VALUE AND THE SOURCES OF FDI According to OECD and IMF classification (OECD, 1996), (IMF, 1993), foreign investments are classified into: foreign direct investments, portfolio investments and other investments. The purchase of, at least, 10% of shares in a company that is resident in the economy other then investors is classified as foreign direct investment. It implies a lasting interest and long term relationship between the direct investor and the enterprise in which the money is invested and significant degree of influence by the investor on the management of the enterprise. Direct investment involves, both, initial purchase of shares and all subsequent capital transactions like reinvested earnings and intercompany debt. The direct investments can be undertaken in buying the existing company (brownfield investment) or in setting up a new entity (greenfield investment). Although, the direct investor can be an individual, trust, fund, government or government agency, the major investors are the largest companies, mostly from developed countries multinational companies. Portfolio investments are purchases of less than 10% of stock in a foreign company, without a lasting interest in a purchased company or involvement in day to day business activities. Portfolio investors are mostly interested in the safety of their investment, likelihood of appreciation in value and return generated (IMF, 1993 a). The other foreign investments consists of intergovernmental loans and similar transactions that are not classified as direct or portfolio investments. The last decade of twentieth century was caracterised by substantial increase in the flow of FDI. Despite some ups and downs the trend has continued until now. In the period , the inflow of FDI has more then quadrupled, reaching 916 bil. 2 Electronic copy available at:

3 USD (Figure 1). They rose by 29% over the value in 2004, having already increased by 27% in 2004 (UNCTAD, 2006). Figure 1 Trends in global FDI flows, (US$billion per year) Source: UNCTAD, 2005., UNCTAD, The largest investor was USA followed by UK. These two countries were also the largest recipients of foreign capital. The UK with 165 bil. USD received the largest amount of FDI in 2005, overtaking USA for the first time since 1977 (UNCTAD, 2006). Numerous measures have been adopted in recent years by countries all over the world in relation to FDI. Market liberalisation, privatisation, especially services like telecommunication, banks and utilities, intensive marketing activities, changes in national laws and reduction of taxes are some of the measures taken in order to make host countries more attractive to foreign investors. The number of international agreements and unilateral measures of relevance to FDI continues to increase. By the end of 2005 the total number of bilateral investment treaties had reached 2495 and double taxation treaties 2758 (UNCTAD, 2006, 9). The Table 1 shows the number of national regulatory changes undertaken in the period

4 Table 1 National regulatory changes, Item Number of countries that introduced changes and their investment regimes Number of regulatory changes More favorable to FDI Less favorable to FDI Source: UNCTAD, World Investment Report 2006, pp 11 The overwhelming numbers of changes were favorable to foreign direct investments. ''Virtually every OECD country has lowered barriers to multinational entry, either unilaterally or through negotiated agreements. Moreover, most OECD countries now have at least one agency wooing FDI, providing information, contacts, and legal support for foreign corporations. Simple economic reasoning provides the explanation for this increased interest in attracting multinational investments. A growing consensus asserts that FDI has positive effects on macroeconomic performance. An increase in the domestic capital stock through multinational investments provides the most obvious mechanism. Capital accumulation drives economic growth in the neoclassical model; thus, FDI should directly and positively impact economic growth'' (Jensen, 2006, 55). 3. CORPORATE TAX RATES AS A REASON FOR INVESTMENTS One of the most frequent measures in wooing FDI, undertaken by both, developed and developing countries, has been the reduction in corporate tax rates. The process began in the mid 1980-s when the UK government of Margaret Thatcher reduced corp. tax rate from 52 percent to 35 percent between 1982 and 1986, forcing other countries to do the same (KPMG, 2006). Leaving domestic economic problems that UK had at the time aside, one of the reasons for reduction in corporate tax rate was desire to make Britain more attractive to foreign investors. According to KPMG International (Figure 2) the average corporate tax rate, amongst 86 analyzed countries, was reduced by 28,7 percent in the period 1993 and 2006, coming down from 38 percent to 27,1 percent. 4

5 Figure 2 Corporate Tax Rates All Countries (%) ,3 37,7 37, Source: KPMG International, ,2 32,932, ,430, ,9 27,227, In the same period the EU countries cut their corporate tax rate by 32 percent (KPMG, 2006). In 1993, when the EU comprised 15 countries, the average corporate tax rate was 38 percent. By 2006, when the EU had 25 members, the average rate was 25,8 percent (Figure 3). Figure 3 Corporate Tax Rates EU ( %) ,3 37, Source: KPMG International, ,5 35,1 34,8 33, ,9 29,7 28,3 26,1 25, What was the effect of all these cuts on inflow of FDI and have the countries with the lowest taxes received the largest amount of FDI? Is tax, and especially corporation tax an important factor for MNC when they decide about their investment locations? 5

6 It seems, politicians thing that the tax is an influential factor for the foreign investors. That, certainly, was one of the main reasons for the described cuts. Academics, however, can not find enough arguments to prove that assumption. In the large number of interviews with the representatives of MNC conducted by N.M. Jensen (Jensen, 2006) says that neither of the interviewed companies highlighted taxes or tax incentives as primary reason for their investments. In many cases taxes did not play any role in their investment decisions. ''Apparently, most firms choose investment location, and then instruct their tax departments to minimize taxes'' (Markusen, 1995, 171). The ability to shift profits from high to low tax location using different trading and accounting practices, makes the level of tax in a certain country much less important to MNC then many governments seem to thing. ''...the data indicate that the United States has less favorable intrafirm trade balances with low-tax countries. This result is anticipated if US sales to affiliates in low-tax countries are underpriced and US purchases from affiliates in low-tax countries are overpriced. Second, additional evidence indicates that trade between US affiliates in different foreign countries is also likely influenced by tax considerations. Sales by affiliates based in low-tax countries are greater than one would otherwise expect relative to sales by affiliates based in high-tax countries'' (Clausing, 2001). Apart from the practices of shifting profits from high to low tax locations, many developed countries have their tax systems designed in a way that gives them a possibility to influence host countries tax arrangements eighth multinational companies. It can be done either in a way that will, in effect, cancel or stimulate (tax sparing) the tax arrangements made by a host country. This further diminishes the importance of tax or tax incentives. The other authors (Dunning,2001), (Stiglitz, 2006) also point out that other things like transport and communication infrastructure and human capital are the most important comparative advantage that a country can offer and that they play much more important role than taxes. When lowering taxes, especially in the case of developing countries, it is often done on the account of spending on education and infrastructure, thus reducing, not increasing, country's attractiveness to foreign investors. The Table 2 shows the ten most attractive developed countries for investment chosen by MNC, and their corporate tax rates. 6

7 Table 2 The most attractive investment locations (developed countries) and their corporate tax rates (percent of responses) MNC responses Corp. tax rates United States (74%) 40% 2. Canada (44%) 36,1% 3. United Kingdom (37%) 30% 4. Germany (35%) 38,34% 5. France (26%) 33,33% 6. Spain (20%) 35% 7. Ireland (17%) 12,5% 8. Japan (17%) 40,69% 9. Australia (13%) 30% 10. Italy (11%) 37,25% Source: UCTAD, MNC responses, KPMG International, corp. tax rates All of the chosen countries, apart from Ireland, have higher corporate tax rates than the average, both, for all countries and for the EU. It, again, shows that the tax is of no significant importance to the country's attractiveness for the foreign investors. The taxes play some role in inflow of FDI only as a part of stable macroeconomic and political climate favorable to the business and investment activity. Taken out of this contest, as a single measure, they are of no importance to the foreign investors. ''However, it should be clear that what matters are the overall conditions in a location, not each policy area in isolation'' (Navaretti, Venables, 2004, 275). Not only that. If the tax was the only or important factor for investment decisions it could have detrimental effect for the world as a whole. As J. H. Mutti says (Mutti, 2003) if a certain amount of FDI is relocated from a country were it is more productive (i. e., has a higher before tax return), to a country were it is less productive (i.e., has a lower before-tax return) world output would fall. 4. FOREIGN DIRECT INVESTMENT IN THE REPUBLIC OF CROATIA Croatia has followed the general trend and reduced its corporate tax rate from 35 percent to 20 percent. Part of a reason for the reduction was desire of the Croatian government to give an incentive to domestic investors and the part to make Croatia more attractive to foreign investors. Leaving aside a question of what impact that measure had on domestic investors, Figure 4 shows the impact on inflow of FDI. 7

8 Figure 4 Inflow of FDI to Croatia mlrd. EUR Source: NBH, The inflow of FDI to Croatia during the war years ( ) was, as one would expect, low and more significant foreign investment activity began since In the period , FDI to Croatia more than tripled (Figure 4). In these years several Croatian banks and part of national telephone company were privatized and most of FDI went into them. But, in these years the corporate tax rate in Croatia was 25 percent in 1996, and 35 percent in the remaining three years. It is clear that the high tax was not an obstacle for the foreign investors. After tax reduction from 35 percent to 20 percent in 2001, there was no increase in inflow of FDI, and, apart from 2003, the value of FDI in all other years was lower than in The level of corporate tax rate in Croatia is now lower then avertage, both, for EU and for 86 analyzed countries. After tax reduction in almost all transition countries in recent years, Croatian tax is amongst highest within that group of countries. The data shown in Table 3 and Figure 5 give us an answer whether there is any connection between the level of corporate tax rate and inflow of FDI amongst transition countries. 8

9 Table 3 Corporate Tax Rates in Chosen Transition Countries Bulgaria* 15 Czech Republic Estonia** Latvia Lithuania Hungary 19,6 19,6 19,6 19,6 19,6 19,6 19,6 19,6 19,6 17,7 16 Poland Romania* Slovakia Slovenia Croatia Note: *Source KPMG, International, 2006 ** from there is no tax on reinvested earnings Source: Institute of Economics, Zagreb, Figure 5 Foreign Direct Investment Per Capita in Chosen Transition Countries in EUR Romania Latvia Bulgaria Poland Lithuania Slovakia Slovenia Croatia Hungary Estonia Czech Republic Source: NBH, There are three countries that have received more FDI per capita than Croatia in the period Two of them (Czech Republic and Estonia) have higher corporate tax rate than Croatia. Czech Republic has the highest corporate tax rate amongst listed transition economies. Yet, with inflow of FDI of 12,5 mlrd. US$ in 2005, it attracted the largest amount of FDI of all ten new EU members (UCTAD, Investment Brief No.1, 2006) while Romania and Latvia have the lowest inflow of FDI per capita, although their corporate tax rates are only 16 percent and 15 percent respectively, i..e. some 10 percent lower than in Czech Republic. This, again, shows that the level of corporate tax rate does not play any major role in attracting FDI. 9

10 The Republic of Croatia is amongst the countries that received significant amount of FDI per capita. But, more than 50 percent of all FDI went into banks, telecommunications and trading sectors, mostly in the companies that had dominant or monopoly position on the Croatian market. The inflow of FDI was directed on capturing Croatian market in the most profitable sectors. Very low proportion of FDI was directed into establishing new companies (greenfield investment) or into restructuring the existing ones, making them more export orientated. Lack of greenfield investments and lack of investments in manufacturing sector are main negative elements of foreign investment activity in Croatia so far. The reduction in the value of corporation tax rate in neither influenced higher inflow of FDI, nor changed their direction towards more greenfield investments and investments into manufacturing, export orientated companies. The recent changes made in national low related to investment, although useful, will not influence a significant change in pattern of FDI to Croatia. In addition to keeping the present political and macroeconomic stability, improving judicial system, fighting crime and corruption and improving training and education system, Croatia needs a well thought and organized activity on attracting several large and well known MNC in car industry, electronic, electrical and information technology encouraging them to invest into establishing new export orientated companies. In a small country like Croatia that would have a significant impact on employment, on transfer of technology, on supporting industry and on Croatian's position in the world as a location that is desirable for foreign investors. 5. CONCLUSION In order to ensure their economic development, the countries all over the world have been competing to attract as much foreign capital as possible. The different measures have been adopted to make host countries more attractive to foreign investors. The reduction of taxes, and especially corporate tax rate, has been one of the most often measures, taken by both, developed and developing countries. This paper shows that reduction in tax, especially taken into isolation, does not play any important role to multinational corporations when they choose locations for their investment. Multinational companies like low taxes and will, ceteris paribus, invest in a low tax country, but only if the low taxes are part of favorable macroeconomic and social environment. Instead of concentrating on lowering taxes the governments, especially in developing countries, will be better advised to use part of the money, that is usually lost when reducing tax, to finance better education, improvements in infrastructure, to fight crime and corruption and to create better social cohesion, as these things are much more important to foreign investors than the level of tax. The Republic of Croatia should also pay more attention to favorable macroeconomic and social environment rather than cuts in taxes. All data produced in this paper indicates that simple tax cuts will attract no one. 10

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