Theories developed to understand FDI
Abstract
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 electric paradigm by Hymer and PLC Theory by Vernon which explains into details the importance of FDIs and the growth that it has gained over time. The best way to answer the research question is through a thorough statistical analysis. For this analysis, the study used 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. 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. 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. In conclusion, according to the study findings, there is a significant correlation between the study variables. The significance level sig=.000.
Key Words: foreign direct investment (FDI); The United Nations Conference on Trade and Development (UNCTAD); Tax Cuts and Jobs Act (TCJA).
1. Introduction
The international economic system has grown into a more globally interconnected framework as a result of a more intense liberalization of financial markets and national economies. This integration, propelled by increasing competitiveness between market participants, has led to the growth in popularity of FDIs (Gallagher & Zarsky,2014). They provide a way of developing strong, sustainable, and long-lasting relations between economies. In the right policy climate, it can act as an effective tool for local business development and can also help to boost the competitive position of both the host and home country. FDI promotes the transition of technologies and know-how between markets. It also offers an opportunity for the host country to stimulate the sale of its goods more broadly on foreign markets. In addition to its beneficial effects on the growth of national and international trade, FDI is a crucial source of capital for a multitude of host and home markets (OECD, 2018).
The study underpins policy considerations concerning 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 about 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. The tax collected is used towards financing public expenditures that may involve infrastructure development and improvement of healthcare within the country for affordability and accessibility of care. This is what makes the study more relevant on reasons as to why further investigation is needed about Countries’ Corporation of tax rates and taxation system outward FDI flows.
A rise in international capital flows has resulted in a more intense financial globalization than trade globalization (Guichard, 2017). As such, understanding the underlying theories and factors which help explain this growth and movement in capital flows has become more imperative. Irrespective of several authors trying to address this problem of the study on how countries corporate tax rates and taxation systems influence outward FDI flows. Literature developed by authors like Moooij and Ederveen (2005), addressed on correlation existing between taxation and FDI with specific reference to estimates of the elasticity of tax of FDI. The results revealed that even though the variability of estimates in elasticity may not surpass depending on the heterogeneity of the available data. This was interpreted to mean that one may even expect a priori that host country heterogeneity may vary or differ insensitivity of FDI to taxation in response to laid policies (involving tax rates level, industry types, business activities, time, periods, and again other factors). Even though the past research kinds of literature have 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. Literature review
2.1. Foreign Direct Investment
The United Nations Conference on Trade and Development (UNCTAD) defines FDI as “An investment involving a long-term relationship and reflecting a lasting interest and control by a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor (FDI enterprise or affiliate enterprise or foreign affiliate)” (UNCTAD, 2007). What distinguishes FDI from portfolio investment is according to the IMF the management dimension. Foreign investment can be seen as an FDI when the investor acquires ten percent or more of the ordinary shares or voting power of a company (IMF, 2003). Over the years, many studies have explored why firms undertake FDI. While there are many schools of thought, there is still no consensus on which FDI theory is the superior one.
2.1.1. The four classic determinants for FDIs
According to Kudina and Jakubiak (2008), there are four classic motives for internationalization. Which includes, natural resource seeking, market seeking, strategic resource seeking, and efficiency-seeking. Historically the most important determinant was the abundance of natural resources. Out of the research they conducted for the OECD, turned out that natural resources on its own do not have such a strong influence on FDI decisions as was claimed by earlier studies. The most important decision-making factor is market seeking. Firms would put more weight to the host country’s market growth and size as well as the per capita income than to natural resources. In a shared second place comes the availability of resources going from natural resources, e.g. minerals, oil, etc to strategic resources like the workforce or know-how. Efficiency seeking receives the littlest attention for FDI decision-making. With efficiency-seeking an enterprise tries to take advantage of the economic system and policy as well as the institutional and market structure available in the host country. The firm tries to concentrate the production facilities in a restricted number of locations to serve a multitude of markets. These four factors are for many multinationals the first criteria that have to be fulfilled before considering FDIs.
2.1.2 Theoretical Framework
2.1.2.1 Electric paradigm theory
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).
There is an overall consensus on the importance of Dunning’s (1988) eclectic paradigm in FDI research. He combined numerous theories, including the theories of imperfect markets and internalization as well as international trade, and augmented them with the locational theory. Dunning states that for a company to participate in foreign direct investment, three requirements must be met at the same time. These are the OLI advantages or Ownership, Locational, and Internalization advantages. The firm ought to have net ownership benefits over other companies that serve the same markets. A firm can have its advantages only if these advantages are firm-specific and exclusive. Patents, know-how, trademarks, etc. are examples of tangible and intangible assets that could potentially give a company an edge over other companies. Secondly, the internalization criteria should be fulfilled. This entails that it should be more beneficial for the business to use the ownership advantages for itself, instead of selling or leasing them to international firms by licenses or management contracts. If the firm would license it out this would be called externalization. Lastly, it should be profitable for the company to leverage these advantages through the combination of production and additional input factors, such as human capital and natural resources from a foreign country. In conclusion, Dunning’s theory states that the more ownership benefits a country’s firms enjoy, the greater their willingness to internalize them, and the more competitive they are to exploit them outside abroad, the greater the possibility of FDI engagement and international production.
2.1.2.2 PLC Theory
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. This is the transition from growth to maturity. It is also during this period that rivals emerge, and the originator of the good then opens a facility in the foreign country to satisfy that demand (Vernon, 1966).
As cited by Lawson, & Bentum-Micah,(2019), on their discussion about the plethora of determinants of FDI and other related factors like political risks, as investment incentives, tax rates among the policy variables, and political stability, cultural distance, market characteristics, wage levels amongst the non-policy variables. In their research a stronger conclusion arrived at that policy variables are more “significant” because policymakers can adjust them rapidly while adjusting non-policy determinants, such as market size and infrastructure, which takes years to change. Changes in tax policy are expected to spur a transition in both domestic and international investment within one to two years. The study results do not support the argument that the incentive levels are a go-to method for countries to attract FDI flows. They warn that it can trigger a response from countries competing for foreign investments, ending in the prisoner’s dilemma trap (Lawson $ Bentum, 2019).In this situation, the prisoners’ dilemma entails that each country knows that if they offer more attractive incentives, compared to the other country, they will attract more FDIs from foreign companies. On the other hand, Globerman and Shapiro (2002), pointed out that FDI in- and outflows are correlated with the political risk of a country. They claim that the smooth functioning of governments, economies, education, and sociocultural is strongly and positively linked to incoming FDI flow.
As referenced by Sethi, Guisinger, Phelan, & Berg, (2003), the determinants for US FDI flows and the stock would be different for Western Europe than Asia. They proved the determinants were indeed different. When considering FDIs US firms would first search for countries with a high Gross National Product (GNP), the proximity of culture, low population density, and relatively low wages. These characteristics would lead the companies to Western Europe. With the specific reason that once the US multinationals encountered lower profit margins, they would give more focus to one of the four classic motives as earlier discussed namely efficiency-seeking. The FDI determinants would change. The cultural proximity to the United States became an obsolete factor. The low wage factor would become more important and receive more weight while the high GNP determinant would receive less weight. All these changes in factors would lead the US FDI flows from Western Europe to Asia (Sethi, Guisinger, Phelan, & Berg, 2003).
According to Grosse and Trevino’s 1996, on their research they analyzed the FDI flows into the United States by country of origin. In general, the bilateral trade between the country and the US as well as the home country’s GDP were the most significant factors for FDI decision-making. The debate in literature caused them to also analyze if the determinants for FDI flows would be different when the home country was an exporting or importing country to or from the US. Of course on economic liberation reducing barriers to trade is very important for it helps in improving the well-being of an economy which is calculated in terms of the total share of the output of goods and services which is measured in terms of GDP. After making this distinction they found that an importing country would be less tempted to make FDIs into the US since the United States already have a competitive advantage compared to the home country. Exporting countries do not differ with the general FDI determinants (Grosse & Trevino, 1996).
As cited by Witt and Lewin (2007), study the interaction between a firm’s strategic needs and the institutional environment the home country offers and in what way a misalignment between both could have a positive correlation with outward FDI. A firm can have its advantages only if these advantages are firm-specific and exclusive. Patents, know-how, trademarks, etc. are examples of tangible and intangible assets that could potentially give a company an edge over other companies. Secondly, the internalization criteria should be fulfilled. This entails that it should be more beneficial for the business to use the ownership advantages for itself, instead of selling or leasing them to international firms by licenses or management contracts that sometimes is referred to as firm strategic needs. Companies located in economies with a high degree of societal coordination are more likely to make outward foreign direct investments than companies located within markets that have high market coordination. This because the latter type of market answers better to the needs of firms than the former. If the needs of firms are answered then they have no reason to commit to OFDI (Witt & Lewin, 2007).On the other hand Witt., (2019), states emerging economies in playing key roles for influencing firm behavior with a combination of foreign direct investment which is abbreviated as (OFDI).In his discussion about state ownership, he realized that the state can influence OFDI in very different ways for example subsidies and policy support.
2.1.2. Past FDI research with a focus on taxation
According to research done by (Boskin & Gale, 1986; Slemrod, 1989), about the relationship between taxes and FDI’s. Except for (Cassou, 1997) all the analyses are based on a single time series (STS). This means the researchers are predicting their findings on observations in various, but equally spaced, periods for a single subject. Since a country’s tax rates don’t change that much over time, an STS analysis will have little to no effect. Cassou stated that since panel data has more sample variability than STS or cross-sectional data panel data will make the estimates more efficient and reliable. Panel data combines cross-sectional data with time series. This means panel data concludes observations for multiple subjects in multiple time intervals. Cassou followed the previous researchers in dividing FDI into two distinct categories, namely reinvested earnings and transfer of funds. Reinvested earnings are in most jurisdictions not subject to corporate taxes. The transfer of funds are funds that are subjected to corporate taxes. Even with panel data Cassou could not significantly link the retained earnings component of FDIs with corporate taxes. The research did show with enough statistical evidence that the transfer of funds factor did get influenced by the corporate tax rate of the country.
According to Wijeweera et al (2009), is one of the few studies focusing on the effect of tax rates and taxation systems on FDI flows. The authors demonstrated that corporate tax rates have an impact on foreign investments. If the statutory corporate tax rate of the home country increases with one percent, the FDI inflows will reduce with 1.1 percent and will increase FDI outflows with approximately 0.6%. This is the average result when no distinction is made between countries with a tax exemption -territorial system- and countries with a tax credit -worldwide system-. Investors located in a tax exemption country are more responsive to a host country tax decrease than investors from a tax credit country. If the host country tax rates would decrease with one percent then FDI flows coming from tax exemption countries would increase with 1.9 percent. The elasticity of the statutory corporate tax rate of tax exemption countries is more than double the elasticity of tax credit countries. A change in home country tax rates has no significant influence on investors from a territorial taxation system. They also agree with previous research stating that GDP is one of the most prominent FDI determinants. A considerable trade history between both countries functions as a complementary factor for FDI decision-making (Wijeweera, Dollery, & Clark, 2009).
As cited by Gan and Qiu,(2014), noted that out of all proposed cross-border mergers and acquisitions (M&A), originating from the US, 66 percent stated the main reason was better tax rates through the merger[1]. Their findings suggest that significant benefits are generated for the US acquirer when the firm takes over a competitor in a more tax-friendly country. Gan and Qiu,(2014), also claim tax differences between countries is a significant factor for M&A type FDIs.
2.2. The international taxation systems
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).
These systems are far from waterproof and multinational companies know this. They spend considerable time and money on finding artificial ways to defer taxes (PWC, 2013). That is why plenty of countries take extra steps by trying to fill the holes in the system. Many countries have Controlled Foreign Company (CFC) regimes that view such foreign subsidiaries’ passive income as though it were received directly by domestic shareholders and require a deduction for relevant foreign income taxes. These regimes are not a perfect solution since loopholes can still be found. This same PWC (2013) report shows that in 2012, twenty-eight of the thirty-four OECD countries had implemented the territorial taxation system. Of these twenty-eight countries, twenty exclude 100 percent of the qualifying subsidiary dividends. The other eight countries exempt 95 percent or more. Most of the twenty-eight countries expand the rules to the active income generated by a domestic organization’s foreign operations. Table 1 gives an overview of the additional rules countries have applied to battle the deferral of taxes.
[1] This research is focused on data pre-2018. This is before the US abandoned the worldwide taxation system.