External financial dependence and FDI responsiveness to corporate tax rates

Abstract

We investigate whether the impact of higher corporate tax rates on foreign direct investment (FDI), at home or abroad, depends on the external financial dependence of a given sector. By structurally relying on debt for the funding of their operations, firms operating in externally dependent (ED) sectors in OECD countries benefit from the tax shield provided by the tax-deductibility of debt interest payments. We conjecture that this tax advantage is likely to make them less sensitive to changes in home and host countries’ corporate tax rates than firms in non-ED sectors when engaging in FDI. Using a new proprietary data on bilateral greenfield manufacturing FDI in OECD countries over the period 2003 to 2010, we find empirical support for this hypothesis as firms operating in externally dependent sectors appear to be much less sensitive to home and host corporate tax rates than firms operating in nonexternally dependent sectors.

Keywords:

• corporate tax rate
• external financial dependence
• foreign direct investment

JEL Classification:

• F23
• H25

Notes

1 ¹ This literature is reviewed by Hines (1999), De Mooij and Ederveen (2003) and Devereux (2007).

2 ² See Brealey et al. (2008) for an excellent introduction to financing and valuation of capital investment projects.

3 ³ Note that the corporate tax shield creates an incentive, irrespective of whether the firm is in an ED or non-ED sector, to use internal loans to finance the activities of affiliates located in high-tax jurisdictions (Grubert, 1998; Desai et al., 2004). This incentive is however substantially limited by thin capitalization rules, imposed in most OECD countries, which deny interest deductions for intra-company loans when the debt to equity ratio of a given firm is above a certain threshold (Buettner et al., 2012). If both firms in ED and non-ED sectors have similar internal debt restrictions in the deduction of interests, the external debt's tax advantage of firms in ED sectors should justify a tax responsiveness differential between both types of firms.

4 ⁴  http://http://www.fdimarkets.com/

5 ⁵  http://http://www.oecd.org/tax/taxpolicyanalysis/oecdtaxdatabase.htm

6 ⁶ http://http://www.heritage.org/index/

7 ⁷ Note that given the relatively large size of these firms and the fact that the United States have well-developed financial markets, it can be assumed that the amount of external funds raised is close to the amount desired.

8 ⁸When the fDi Markets categories covered several industrial sectors, we used the median value of the sectors’ measure of ED.

9 ⁹ The ED broad sectors are Wood products Paper, Printing, Packaging, Rubber, Plastics, Business Machines & Equipment, Engines & Turbines, Industrial Machinery, Equipment & Tools, Medical Devices, Electronic Components, Consumer Electronics, Semiconductors, Aerospace, Automotive OEM, Non-Automotive Transport OEM.

10 ¹⁰ Tax rate elasticities of FDI in ED sectors and their corresponding SEs are reported after each interaction term in Table 1.

11 ¹¹ R&D intensity is the share of R&D spending in total sales as computed by Kroszner et al. (2007), using data from Compustat on all publicly traded US-based firms over the period 1980 to 1999.