Evolution of the taxation systems in OECD countries

The first case of a territorial taxation system originates from New Zealand. In 1891 New Zealand approved the “Land and Income Tax Assessment Act”. Many countries followed in New Zealand’s footsteps and switched from a worldwide taxation system to a territorial one. Even though the European Union (EU) lets the member countries choose freely which taxation system they want to apply. The expansion of the EU was a catalyst in the popularity growth of the territorial system. Ireland is the only EU OECD country that uses the worldwide method (PWC, 2013). Nowadays, only five countries have a true worldwide taxation system. These are Chile, Ireland, Israel, Korea, and Mexico. The United States of America (U.S.A.) used to be a pure worldwide taxation regime (Matheson, Perry, & Veung, 2013). This changed in 2017 when they passed the Tax Cuts and Jobs Act (TCJA). The US-designed a hybrid version of the two systems (Pomerleau, 2018). In all of history, there have been two cases where a country changed from a territorial to a worldwide taxation system, this was the case for New Zealand in 1988 and Finland in 1990. Both instances have been undone in the early 2000s after they witnessed the so-called “lockout” effect. In the case of a worldwide system, the foreign subsidiaries would be subject to a surplus of home country tax if they want to repatriate their earnings. This effect creates a significant loss in international competitiveness which locks these companies out of the international competition (PWC, 2013).

Figure 1 Number of Countries with a Territorial Tax System among 34 Current OECD Member Countries,

1.2.            Different taxation system

Multinational companies are non-stop looking for ways to reduce their cost of taxes. A good way to accommodate this need is through FDI. The so-called tax inversions or corporate inversions is one of the most popular ways to reduce taxes through FDI.Before 2017, tax inversions were extremely popular in the U.S. (Raice, 2014). The U.S. had the second-highest corporate tax rate in the world, 40 percent (Moskowitz, 2020). This high tax rate combined with the worldwide taxation system reduced the competitiveness of U.S. based companies. To battle this ineffectiveness many U.S. companies opted for tax inversion (Raice, 2014). Kagan (2019) describes this phenomenon as where a business will reintegrate overseas by making a foreign company buy its current operations. The foreign company then owns the assets, the old entity is dismantled, and the business is now legally domiciled in the new country, though staying the same in its everyday activities. Firms may also acquire or merge with a foreign company and use it as their new headquarters.

Moving the headquarter of the company to a country with a territorial tax regime is a relatively effortless way of reducing this cost. At the beginning of the millennium, only seventeen percent of the Forbes 500 companies were headquartered in a territorial country. By 2012, this number more than tripled to 61 percent. If we leave the US-based companies out of the Forbes 500 statistics, then 91 percent of the companies are headquartered in a territorial regime. In 1980, 22.4 percent of total OECD outbound FDI stock came from countries with territorial tax systems, compared with 69.9 percent in 2011. This can be explained by the increase in numbers of countries adopting the territorial system, but also by businesses paying fewer taxes within the territorial system, leaving them with more capital to spend elsewhere (PWC, 2013).

Figure 2 Outbound Stock of FDI from Worldwide and Territorial Tax Countries

2.5 Research Gap

The study underpins policy considerations about taxation of foreign direct investment (FDI) with study main objectives like providing a review of an empirical study on matters concerning the effect of taxation on FDI flows. This will address reasons and factors that address variations in the sensitivity of FDI on taxation. This purely depends on different methods of economic principles used in analyzing the effect of tax on FDI by policymakers. The second scenario involves analyzing developmental policy concerning the handling of tax for both inbound and outbound on FDI among the OECD member counties (OECD, 2020).

According to OECD, (2020), the policy framework for investment main targets relies on policymakers for transition economies and development. They have the mandate of proposing guidelines in different fields like taxation to identify priorities and develop actual strategies. There is a lot of literature in taxation with several pros and cons of corporate tax incentives and on the other hand tax designs that help in attracting FDI, again boost revenue that is used towards infrastructure development. In the context of OECD, (2020), policymakers should see into it whether specific countries they represent have tax burden on an inward-bound venture where the risk or return opportunities are offered with consideration of framework conditions. The framework conditions may entail political/fiscal stability/monetary, public governance, and legal protection.

Several theories have been developed to understand FDI (i.e. PLC theory / eclectic paradigm). For instance, Dunning’s OLI framework seeks to explain when firms should undertake FDI. To begin with, the first theory of the electric paradigm was developed by a scholar (Hymer, 1976). He realized in his findings that FDI flows are driven by the need to minimize or eliminate foreign competition among companies, as well as the wishes of multinationals to increase their returns. Hymer laid the groundwork for many studies to come (Hymer, 1976). Secondly, PLC theory was developed by Vernon, (1966), which explains into details the importance of FDIs and the growth that it has gained over time since the Second World War. Vernon explains this shift through his PLC theory, or also known as the Production Life Cycle theory. Companies experience four evolutionary cycles according to his theory: innovation, growth, maturity, and decline. In the first stage, new goods are created, manufactured, and distributed in the internal markets. If the product succeeds, manufacturing increases, and export gets developed by penetrating new markets. Even though the past research literature has no specific research work about investigating How countries’ corporate tax rates and taxation systems influence outward FDI flows and that is why the researcher is interested in filling this research gap.

2.          Statistical analysis

In this section, we will first talk about the different hypotheses and the reason these have been chosen. Then the data and methodology will be explained in detail as a preparation for the actual analysis.

2.1.   Impact of corporate income tax rates on OFDI

According to Pinto (2016), tax considerations are an important element in a firms’ international competitiveness. A higher corporate income tax rate is a significant disadvantage in the field of international competitiveness. Besides, Pinto claims that a decline in the corporate tax rate will cause a rise in inward FDI flows. The influence that corporate taxes have on outward FDI flows stays under-researched. Based on this information our first hypothesis is formed. Hypothesis 1:  A home country’s corporate income tax rates have a positive effect on outward FDI flows. The study hypothesis is in connection with other studies conducted in the past for example according to the worldwide system, income generated abroad by foreign subsidiaries is subject to tax by the home country with an income tax refund owed to foreign governments. Many countries restrict this refund or credit to home country tax on foreign income. In contrast to the worldwide taxation, there is the territorial system, also known as the “participation exemption” method. Here the income generated internationally by foreign branches is completely or partially excluded from home country tax with no refund for foreign taxes. The big difference between these two systems is that under the territorial system qualifying foreign branches’ earnings may be repatriated with little to no tax. With worldwide taxation, the repatriated earnings are subject to extra tax if the foreign rate is lower than the home country’s rate (PWC, 2013).

2.2.   The moderating effect of taxation systems

Pinto (2016) points out that not only do the tax rates have an impact on FDI inflows but also that the country’s tax system, and the tax system’s complexity, are significant determinants. The literature study demonstrates that firms located in a worldwide taxation system are also taxed on their foreign income. Since they are less likely to realize tax savings by shifting their domestic income abroad, we expect the OFDI flows to be stronger for countries in a territorial system. Hypothesis 2: The positive effect of a home country’s corporate income tax rates on outward FDI flows is stronger when a country applies a territorial taxation system. In connection to the past literature According to OECD, (2020), the policy framework for investment main target relies on policymakers for transition economies and development. They have the mandate of proposing guidelines in different fields like taxation to identify priorities and develop actual strategies. There is a lot of literature in taxation with several pros and cons of corporate tax incentives and on the other hand tax designs that help in attracting FDI, again boost revenue that is used towards infrastructure development. In the context of OECD, (2020), policymakers should see into it whether specific countries they represent have tax burden on an inward-bound venture where the risk or return opportunities are offered with consideration of framework conditions. The framework conditions may entail political/fiscal stability/monetary, public governance, and legal protection.

2.3.   Data and method

This section outlines the techniques required to investigate the hypotheses. Firstly, we elaborate on the methodology. This subsection describes the way the research will be conducted. A short clarification of the population and sample will be made. Lastly, the variables will be discussed. These are divided into the dependent, independent, moderating, and control variables.

2.3.1.      Methodology

The best way to answer the research question is through a thorough statistical analysis. For this analysis, we have a choice between cross-sectional data, time series, and panel data. Cross-sectional data entails that the figures are about multiple individuals, in this case, countries, at a single point in time. Time series is the opposite of cross-sectional data. Here, there is one individual at multiple points in time. As Cassou (1997) pointed out, the use of time series in this type of research is impractical. Cross-sectional data will not give an evolutionary view which makes this kind of data useless. Therefore, we opt for a combination of both types of datasets, namely panel data or also known as longitudinal data. Panel data combines multiple individuals with multiple periods. This is the ideal type of data to track changes or trends over time.

2.3.2.      Population and Sample

The literature study elaborated briefly on the fact that most outward FDI flows originate from OECD member states. They were, in 2018, responsible for almost 70 percent of all FDI outflows. Reliable data about outward FDI flows is not easily accessible for every country. Trustworthy sources like UNCTADSTAT, IMF, OECD, KPMG, and PWC offer this data for the OECD countries. Therefore, we will narrow down the data analysis to the OECD countries.

2.3.3.      Variables

2.3.3.1.            Dependent variable

The research question states that this research’s main interest is the way outward FDI flows are affected by a country’s corporate tax rate and by the country’s international taxation system. The outward FDI[1] flow is the dependent variable. The corporate tax rate as well as the international taxation system are the independent variables. The data for the outward FDI flow has been supplied by UNCTADSTAT (2020).

2.3.3.2.            Independent variable

There are multiple types of corporate tax rates,, there is the statutory tax rate. This tax rate is the tax rate that has been formally conveyed by the government to the firms in general. They do not consider advanced pricing agreements lobbied by individual firms or research and development incentives that may alter the true tax rate of a firm. Contrary to the statutory tax rate the effective tax rates (ETR) do take these possible tax-related rules into account. ETRs are subdivided into backward- and forward-looking tax rates. Backward-looking tax rates look at the actual taxes firms paid in a past period, while forward-looking tax rates are estimates of what a firm would pay while keeping all the tax-related rules in mind. Backward-looking ETRs are best used on a firm-specific level while statutory tax rates are better for country-level analysis (Lammersen, 2002).

2.3.3.3.            Moderating variable

The second independent variable is the country’s international taxation system[2]. This data could be compiled based on PWC’s report on territorial tax systems (PWC, 2013). The data for moderating variable was coded as a dummy variable with 1 with countries with a territorial system and 0 for countries without a territorial system or on the other hand for countries with a worldwide system.

Figure 3: Screenshot of study data

2.3.3.4.            Control variables

When conducting statistical research, one should not simply look at the multiple correlations, without including control variables. Most likely, a simplistic analysis will have an omitted-variable bias. This means that the findings could be influenced by other variables however these variables are not included in the study. To avoid an analysis with an omitted-variable bias “control variables” are added. These are chosen based on the past literature and/or intuition.

The first control variable is the country’s economic size. Lim’s research for the IMF showed that a bigger or growing economy will have a higher absolute number of FDI outflows than a smaller or shrinking economy (Lim, 2001). The economic size of a country is best expressed in Gross Domestic Product (GDP). The IMF defines GDP as follows “GDP measures the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period” (Callen, 2020). The monetary value used is the US dollar value at the time of writing. The data was issued by the World Bank (2020a).

The second control variable is the level of economic development. The literature study showed that the more developed a country is the more they will invest abroad. Grosse and Trevino (1996) pointed out that not including this variable would cause an omitted-variable bias. They suggest measuring this variable through GDP per capita. There does not seem to be a consensus about one clear economic development definition. GDP per capita is a good start but economic development is broader than that. Therefore, I suggest adding the World bank’s Economic Fitness (EF) measure[3]. The World Bank says this measure reveals information about the development and growth of a country. The EF variable is a rank of 1 to 149, where 1 is the best score (Metadata Glossary, 2020c). The GDP per capita data as well as the EF measure are provided by the World Bank (World Bank, 2020b, 2020c).

The concept of governance is widely debated among legislators and academics, a common definition of governance or institutional quality has not yet been fully embraced. The definition we apply is based on the World bank’s view on governance (World Bank, 2020d). They divide governance into three parts. The first part is the way governments are elected. The second part is the effectiveness of the formal institutions in formulating and implementing policies. Lastly, there is the esteem of citizens for the governing institutions. These three aspects can each be broken down further into two subdivisions. For the first one, there is the “voice and accountability” part and the “political stability” part. The former is the degree to which the citizens are free in selecting their representatives, freedom of expression and media, etc. The latter talks about the probability the government will be overthrown. The effectiveness of institutions is measured by the “regulatory quality” and the “government’s effectiveness”. The regulatory quality is the government’s capability to formulate and enforce policies and regulations enabling and encouraging the growth of the private sector. The government’s effectiveness is based on the quality of the public and civil services as well as the degree to which these services are independent of political pressure. The respect for the institutions is subdivided into the “rule of law” and “control of corruption”. The rule of law is meant the quality of rights, police enforcement, the courts, and the crime rates (Kaufmann, Kraay, & Mastruzzi, 2010). When a country has a high standard of governance foreign firms will be more likely to invest. A country with low governance brings more risk and has a negative correlation with FDI inflows (Younsi & Bechtini, 2019). The data for these six aspects of governance are summarized into the World bank’s worldwide governance indicators[4] (World Bank, 2020d). Since these variables are likely highly correlated, we converted these into one composite index. This will avoid multicollinearity issues. The last control variable is the country’s international trade intensity. A country’s international trade intensity comes down to the import and export of goods and services (World Bank, 2020b). This variable is expressed as a percentage of the country’s GDP.

3.          Results

Descriptive Statistics

The results of the study were based on study research hypotheses: Hypothesis 1:  A home country’s corporate income tax rates have a positive effect on outward FDI flows and Hypothesis 2: The positive effect of a home country’s corporate income tax rates on outward FDI flows is stronger when a country applies a territorial taxation system. Therefore the study started with descriptive statistics that involved mean, mode, median, and standard deviation as shown below.

Table 1

Descriptive Statistics

The study descriptive statistics involve the study’s first hypotheses beginning the year 1996 on OFDI flow to 2018 OFDI flow and again the same years for Corporate Tax Rate. The study revealed different mean values and standard deviation in every year for both OFDI flow and corporate tax. This may be interpreted to mean in every year there is different budget incurred in every country and these budgets are different in terms of priorities for all countries. That brings different means and standard deviations seen for over the years since 1996 to 2018.

Graphical Presentation of Descriptive Statistics

Figure 4: Graphical Presentation of Descriptive Statistics

According to the results of the descriptive statistics between 2008 to 2012 is when most countries experienced an impact in OFDI low and corporate tax at its peak.

[1] UNCTADSTAT mentions that due to the Mexican crisis in the late 1990s no reliable data could be found for the Mexican outward FDI flows from 1996 until 2000. Therefore during these years, the outward FDI flows have been put on zero.

[2] For Latvia and Lithuania, it is unclear when they implemented the territorial taxation system.

[3] The World bank introduced the EF measure in 1995. Therefore, 1995 is the starting point of this data. Luxembourg is not included in this measure.

[4] The World bank introduced the worldwide governance measures in 1996. Therefore, 1996 is the starting point of this data.