Chains of Ownership, Regional Tax Competition, and Foreign Direct Investment

It is an article of faith – among politicians as well as scholars – that government policies have the potential to influence the extent and nature of economic activity, particularly when policies impede the normal functioning of business. Examples include regulatory regimes that discourage business formation, legal systems and institutions that make it difficult to execute and enforce commercial contracts, and tax systems that impose excessive burdens on income-producing activities. The desire of most governments to attract foreign direct investment (FDI) directs special attention to the way in which policies affect the location and activities of multinational firms. The purpose of this paper is to consider the impact of taxation on FDI, emphasising the effects of tax differences within regions (Europe in particular), and the behaviour of FDI financed through chains of ownership. The effect of taxation on FDI has received considerable prior attention in the economics literature, where there is an emerging consensus that taxation strongly influences both the volume of FDI and the operational behaviour of multinational firms. The evidence suggests that high tax rates discourage FDI not only by depressing after-tax investment returns but also by changing the opportunities available to firms that have discretion in reporting the location of taxable income. Much of the prior research on the impact of taxation on FDI draws conclusions based on the behaviour of American multinational firms. This tendency, which reflects the ready availability of data on American companies, implicitly emphasises the incentives created by the U.S. tax system. Since the U.S. tax system differs in important respects from tax systems in many other countries, it is possible that the effects of taxation on non-American investors differ from those established in the literature. In particular, the foreign tax credit system used by the United States is