Taxes and the size of the foreignowned capital stock: which tax
rates matter?
Michael P. Devereux
Ben Lockwood
University of Warwick
Plan
• Aim of paper:
– to revisit issue of impact of corporation tax on
international flows of capital
– basic idea: test which tax rate – or rates – are relevant
• Describe simple analytical model of multinational
investment
• Describe data, including measures of tax rates
• Describe regression analysis and results
Simple Analytical Framework
•
Single firm enters a regional market of n
countries:
–
–
•
fixed costs of setting up plant
transport cost of final good between countries
Three-stage choice:
1. Locate plant in which country?
2. Conditional on location; choose investment
3. Conditional on investment, choose sales in all
countries
Stage 2
• The firm located in a given country will invest there
until: post-tax expected rate of return = post-tax
cost of capital
• The impact of tax on this decision depends only the
effective marginal tax rate, EMTR
• EMTR: percentage increase in cost of capital due to
corporate taxes
Stage 1
• We assume for simplicity that the fixed cost of
investment is high enough so that the firm locates in
only one country
• firm chooses option with highest post-tax profit
• Generally, location depends on the effective
marginal tax rate and the effective average tax rate
(EATR)
• EATR: percentage of total profit taken in corporate
tax
Key Predictions
• Generally, a firm’s investment in a given country
will depend both on the EMTR and the EATR
• But, if plant scale is difficult to change, the
EMTR will be unimportant in determining
investment
• On the other hand, the EATR will always be
important in determining investment
Average versus marginal
EMTR: percentage increase in cost of capital
due to corporate taxes
EATR: percentage of total profit taken in
corporate tax
• They can be very different: e.g. cash flow
tax, with EMTR=0 and EATR=statutory
rate
EATR v EMTR, 1984
EATR
40%
30%
20%
10%
0%
0%
10%
20%
EMTR
30%
40%
Other issues for empirical analysis
• Existing plants?
– framework unchanged, firms but more likely to expand
existing plant; hence introduce some dynamics in
regression analysis
• Aggregation
– allowing for differences in costs, etc, firms make
different choices
– “add up” over firms to generate aggregate investment
by foreign multinationals in each country
– We use probabilistic choice framework of McFadden
to do this explicitly, implies that dependent variable is
log of the capital stock
Investment Data
• Don’t use FDI flows
– financial, not real
– May underestimate real investment because it does not include
domestically financed investment by multinationals
• Use data on activities of foreign affiliates of US
multinationals
– majority-owned non-bank affiliates of non-bank parents
– from US Department of Commerce, Bureau of Economic Analysis)
• aggregated within each country, for 20 OECD countries,
1983 to 1998
– Data on capital, sales, profit
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P o nd
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Average Capital Stock owned by Affiliates of US
Multinationals, 1983-1998 ($billion, 1995)
60
50
40
30
20
10
0
Development of capital stock and investment
over time ($ billion, 1995)
40
30
20
10
0
1983
-10
1985
1987
1989
Total investment
1991
1993
1995
Mean capital stock
1997
Measuring Tax Rates
Common empirical approach based on
hypothetical investment:
– Given cash flows, can find cost of capital (EMTR)
and EATR
– Measure each for several forms of investment and
take weighted average
– Include only source-based corporation tax
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tax rate
Statutory Corporation Tax Rates
1983 and 1998
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1983
1998
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Effective Average Tax Rates
1983 and 1998
0.6
0.5
0.4
0.3
0.2
0.1
0
1983
1998
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Effective Marginal Tax Wedge
1983 and 1998
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
1983
1998
Regression Analysis
• Examine whether investment by affiliates of US
multinationals depends on EATR, EMTR or both
• allow for other factors:
– Country characteristics (Openness to trade and capital flows,
size of economy and public sector, demographics)
– Characteristics of affiliates in a country (level of sales, size
of existing capital stock)
– Characteristics of affiliates are treated as endogenous and
instrumented
– Country and year fixed effects
Regression Results
dep var:
EATR
cost of capital
 it
R2
Observations
1
ln(Kjt)
-0.478
(3.72)**
0.998
266
2
ln(Kjt)
-0.083
(0.24)
-
3
ln(Kjt)
-0.280
4
ln(Kjt)
-0.460
(3.99)**
-0.208
(0.60)
-
5
ln(Kjt)
-0.456
(2.90)**
-0.205
(0.61)
-0.004
0.998
266
(2.64)*
0.998
266
0.998
266
(0.04)
0.998
266
Interpretation of Results
• Evidence of significant role of effective average
tax rate
– 1 percentage point fall in EATR generates 0.46% more
investment in the short run, and 1.44% more investment
in the long run
• But no role for effective marginal tax rate
• Consistent with (and indirect evidence for):
– Scale of plants relatively fixed
– But plants mobile between countries