Tax Incentives and Foreign Direct Investment in China

Tax Incentives and Foreign Direct Investment in China Minchung Hsu 1 Junsang Lee 2 Roberto Leon-Gonzalez 3 Yanqing Zhao 4 Abstract The preferential tax policies for foreign direct investment (FDI) in China were terminated by a tax reform in 2008. This paper uses the provincial-level panel data for 1998 to 2008 before the reform in order to study whether the tax incentive had been a significant determinant of foreign investment decisions. We find that market size and geographic location had significant impacts on the FDI inflow into China but the tax incentive policies were not a sufficient determinant of FDI inflow into China over the periods studied, which provides a rationale for the termination of the tax incentives in FDI at 2008 reform in China. JEL Classification: F21, H54, H71 Keywords: Tax Incentives, Foreign Direct Investment, Fiscal Policy, Tax Reform 2 National Graduate Institute for Policy Studies, Tokyo, Japan. Email: minchunghsu@gripd.ac.jp. 2 Corresponding author, Sungkyunkwan University, Seoul, Korea. Email: Junsanglee@skku.edu 3 National Graduate Institute for Policy Studies, Tokyo, Japan. Email: rlg@grips.ac.jp. The views expressed in this paper are those of the authors and do not reflect the views or policies of the State Administration of Taxation of China. 4 The State Administration of Taxation of China, Beijing, China. Email: zhaoyanqing@chinatax.gov.cn. 1

1. Introduction The opening of the market in 1979 was associated with a preferential tax policy for FDI within five special economic zones in China. After that, similar tax policies to attract FDI were continuously introduced and spread out to other areas across China. However, the 2008 tax reform in China terminated these preferential tax policies for FDI. Many studies investigate the effectiveness of tax incentives which are intended to induce more inward foreign direct investment in developing countries However, there is mixed evidence of the relationship in the literature. 5 This paper uses the provincial-level Chinese panel data for the years from 1998 to 2008 to study the determinants of FDI inflows in China before the reform that terminated the tax incentives. We use the provincial-level panel data to take into account the regional heterogeneity including regional market size, geographical locations and the degree of tax incentives (preferential tax treatment indicators). The previous literature on the FDI determinants in China mainly relied upon nationallevel aggregate data (Fetscherin et al., 2009, Fan et al., 2009). Broadman and Sun (1997) studied this particular issue with provincial-level but cross-sectional data in 1992 due to data limitations. Many of the previous studies heavily focus on the periods in the 1980s and the 1990s to study the effects of tax incentives on FDI (Sun et al., 2002) This study uses a system GMM estimation of panel data model, which suggests that market size and geographic factors had a significant impact on FDI inflows in China over the periods studied, whereas the effect of the tax incentives was not statistically significant even though it is positive. This finding is consistent with Lin and Wang(2014) and implies that the tax incentive policies did not play a significant role in FDI inflows to China over the last decade before the termination of tax incentives. Up to our knowledge, this is the first paper to provide a justification of termination of the tax incentives for FDI inflows in 2008 reform. This finding also indicates that the 2008 tax reform would not have a significant impact on FDI inflow into China. 5 See Hinady and Orviska(2014), James and Van Parys (2010) and Van Parys (2012) for more details. Also Echandi, Krajcovicova and Qian (2015) provides a review of literature on the impact of investment policy. 2

2. Data and Variable Measurement The data in our analysis are mostly collected from the Statistical Yearbook of China and the data for province-level FDI inflow are from the Ministry of Commerce (MOC) in China. Nominal variables are made real terms in 2005 prices in RMB. The data for the FDI determinants are summarized in Table 1. Especially, we construct preferential tax policy index to measure the provincial heterogeneity in the degree of tax policy across regions and times as in Démurger et al. (2002). Table 1. Variables, measurements and expected effects Category Independent Variable Variable LogFDI Factor represented FDI inflow Measurement The natural logarithm of annual realized FDI inflow into a province GDPGR Expected return on investment National GDP growth rate from World Development Indicators WTO WTO accession Dummy (value=0 for 2001 and before; value=1 after 2001) GOVQ Institution quality Governance quality index (World Governance Indicators) Explanatory Variables Distance Geographic disadvantage The shortest distance from the capital city of a province to Beijing, Shanghai, or Guangzhou LogPGDP Market size The natural logarithm of provincial real GDP LogFDIstoc k Agglomeration The natural logarithm of FDI stock density in a province Wage Labor cost The provincial average wage Patent Road The level of scientific research Infrastructure quality The ratio of annually approved patents in a province to the aggregate annually approved amount The density of road systems in a province (the length of the roads in a province divided by the province's area) TXI Tax incentive Preferential tax treatment index 3. Model Specification Follow Blomstrom et al. (1992) and Sun et al. (2002), we use a one year lag for all of the explanatory variables except for the variables related to the tax incentive policies and for WTO accession, which 3

are less likely to be caused by the FDI inflow, and except for the time-invariant geographic factor. In order to correct the potential heteroskedasticity, the GLS is conducted in the fixed effects and the random effects panel regressions. We also use a system GMM model with robustness check, which uses lagged level and difference variables of the dependent variables as instrument variables as in Arellano and Bover (1995) and Blundell and Bond (1998). = + + + + + + + + + + + +, 4. Empirical Results This study used panel data to examine the determinants of the FDI inflow across Chinese provinces over time. Table 2 reports the empirical results and the results of the associated tests for the random effects and the system GMM model. 5. Discussion Table 2 shows LogPGDP and Distance have stable statistical significance in system GMM model. This result indicates that market size and geographic location are important factors that have affected the provincial FDI inflows over the decade before the tax reform. A 1% increase in the real provincial GDP leads to a 0.0883% increase in the FDI inflow. This finding is consistent with the results reached by Sun et al. (2002) that focused on China and with other research that studied the US and other countries. Distance, as a proxy of geographic disadvantage, has a negative impact on FDI inflow, which is statistically significant. This finding shows that the geographic location of the host province is important when making FDI decisions. The remote inner provinces are far from the coast and the commercial/political centers, and so it is less convenient for foreign investors to allocate their investments in these provinces. Our study focuses on the effect of the tax incentive policy, TXI, on FDI inflow. It shows a 4

positive relationship with LogFDI, but it is not statistically significant. This result indicates that the tax incentive policy did not play an significant role in attracting FDI over the last decade before it is terminated. This finding is opposite to the findings of Tung and Cho (2000) and Cheng and Kwan Variable Table 2. Regression Results (1) Random effect (GLS) (2) Fixed effect (GLS) (3) Pooled GLS (4) System GMM LogFDI(-1) 0.976 *** (0.0317)) GDPGR 0.0201 0.0244 0.685 *** -0.0284 (0.57) (0.52) (5.19) (0.0382) WTO 0.0328 0.0263 0.126 0.104 (0.44) (0.30) (0.32) (0.0712) GOVQ 0.608 0.509-2.652-0.513 (0.80) (0.69) (-0.83) (0.780) Distance -0.00167 ** -0.00152 *** -0.000173 ** (-2.65) (-3.90) (7.37e-05) TXI 0.0171 0.0280 0.646 0.0688 (0.21) (0.39) (1.89) (0.0787) LogPGDP 0.925 ** 0.662 1.348 *** 0.0883 ** (3.21) (1.50) (5.91) (0.0406) Wage -0.000045 *** -0.0000343 * -0.000248 *** -2.77e-06 (-4.18) (-2.15) (-5.68) (9.89e-06) LogFDIstock 0.601 *** 0.660 *** 0.779 *** -0.0588 (5.40) (5.64) (8.04) (0.0439) Road 0.00106 0.00112-0.0223 *** 0.00224 (0.52) (0.37) (-3.45) (0.00185) Patent 0.00985 0.0147-0.0682-0.00905 (0.46) (0.47) (-1.68) (0.00661) Constant 11.89 *** 11.76 *** 2.305 0.368 (5.58) (4.24) (0.94) (0.504) N 330 330 330 300 R 2 0.801 R 2 overall 0.7096 0.6687 R 2 within 0.4924 0.4943 R 2 between 0.7128 0.6732 Hausman X 2 12.96 *** Breusch-Pagan LM X 2 1171.97 *** Sargan test (p-value) 0.103 Hansen J test (pvalue) 0.928 ar(1)-test (p-value) 0.00555 ar(2)-test (p-value) 0.847 Note: t statistics in parentheses. * significant at 5% level; ** significant at 1% level; *** significant at 0.1% level. (2000), which use data from 1986 to 1995. The effect of the tax incentives on FDI has been inconclusive theoretically and empirically in the literature. Examining the rate of return on assets, the tax incentives do influence the investment decisions of enterprises (Scholes and Wolfson, 1992). 5

However, Lin and Wang(2014) and Arnold and Mclntyre (2002) argue that the effect of the tax incentives on the selection of an FDI location was limited. They suggested that the tax incentives became important when determining the structure of an FDI and only after the investment decisions had been made. From the other point of view, Doyle and Sweder (1994) and Bond and Samuelson (1986) proposed a theoretical model to show that the tax incentive policies work as a signal from the host countries to invite FDI, especially when there is incomplete information between the host countries and the foreign investors. Empirical studies concerning the effect of the tax incentives also show mixed results (for a detailed review, refer to Tung and Cho (2000). As proxies for the entire investment environment in China, the expected return on general investment (GDPGR), WTO accession (WTO) and institutional quality (GOVQ) variables are all positive but statistically insignificant. These variables control for the possible effects of period individual-invariant factors on the FDI inflow. The WTO accession in 2001 has been viewed as an important event in China s development because it is a milestone for market openness. However, with the most recent data, we find that the effect of the WTO accession on FDI is insignificant, although positive. Road and Patent also show positive but statistically insignificant effects. These results imply that infrastructure development and the quality of human capital are not crucial to FDI decisions on China, and they are consistent with the findings in Sun et al. (2002). 5. Conclusion This paper uses the provincial-level panel data for the last 10 years (1998 to 2008) before the reform terminated the tax incentives for FDI in China in order to study whether the tax incentive was an important determinant for foreign investment decisions. Up to our best knowledge, this is the first paper to provide a justification or/and a rationale for the termination of the tax incentive for FDI in China. We find that market size and geographic location had significant effects on the FDI inflow into China but the tax incentive policies were not a sufficient determinant of FDI inflow into China over the periods studied. 6

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