ec689 impactfdi policyhandout

MNC Impact & FDI Policy

Economics 689 Texas A&M University

Glass & Saggi 1999

• Glass, Amy J. & K. Saggi (1999), “FDI Policies under Shared Factor Markets,” Journal of International Economics 49(2): 309-332. – Examines the consequences of FDI across countries:

• shifts labor demand across countries.• raises wage in the host country and lowers the wage in

the source country.• benefits host workers at the expense of source workers.• reduces profits of host firms by raising wages abroad.

– Tension arises between worker interests and firm profits in the two countries.

Glass & Saggi JIE 1999

Model• One factor, skilled labor, available in fixed supply in each

country.• n industries with homogeneous goods. All demand in a third

country.• One unit of each good is produced using one unit of skilled

labor.• m identical source firms and M identical host firms in each

industry.• Market for skilled labor is competitive. Firms take wage as

given. The wage for skilled labor in the source country is zand in the host country is Z.


Output market• Let yj denote output of a representative source firm

in industry j.• Total industry output of source firms is myj

• Let capital letters denote the host.• Output of a representative host firm is Yj

• Total industry output of host firms is MYj

• Total output is Qj = myj + MYj the sum of source and host production by firms in industry j.


FDI decision• Each source firm decides whether to produce each

unit at home or abroad.• Let aj denote the share of skilled labor demanded

abroad by a source firm in industry j, which provides a measure of the extent of FDI.

• Host firms do not undertake FDI in the source country. FDI seeks lower production costs, so in equilibrium FDI occurs in only one direction.


FDI subsidy• Suppose source firms are offered a subsidy sj for

each unit of output produced in the host country.• If sj > 0, subsidy acts like reduction in host wage for

source firms.• Negative values of subsidies are taxes.• Net marginal cost of a source firm is cj = (1 – aj) z +

aj (Z – sj)• Marginal cost of a host firm is Cj = Z.• All firms take source and host wages as given.


• Source wage must equal host wage minus subsidy z = Z – sj for production by source firms to be split across countries 0 < aj < 1.

• FDI subsidy places a wedge between source and host wages.


Output choice• As Cournot oligopolists, each firm picks its

quantity to maximize its profits, given the quantity chosen by the other firms.

• In a symmetric equilibrium, all industries are identical and thus source firms split production across countries to the same extent regardless of industry.


Labor market• Only a fixed supply k of skilled labor per industry is available

in the source country, so the wage must adjust to equate the demand for skilled labor with the supply of skilled labor.

• The source labor constraint is (1 – a) my = k• The source labor constraint relates production of each source

firm to the extent of FDI and implicitly the source wage.• Similarly, only a fixed supply K of skilled labor per industry is

available in the host country.• The host labor constraint is amy + MY = K


• Adding the source and host labor constraints dictates that the total production of each industry is constant.

Q = my + MY = k + K• With symmetric industries, the fixed availability of skilled labor

in each country fixes total output in each industry.• This aspect of the model greatly simplifes the analysis since,

in equilibrium, price and total output in each industry are unaffected by government policy.

• Only FDI responds to policy and thus FDI affects the equilibrium through the changes in wages induced by FDI.


General equilibrium• An equilibrium must specify the output of a representative

source firm y, the output of a representative host firm Y, the source wage z, the host wage Z, and the extent of FDI a of a representative source firm.

• The solution to the system of equations: the FDI equilibrium condition, the first order conditions, and the labor constraints.

• The key parameters are the source skilled labor supply per industry k, the host skilled labor supply per industry K, the number of source firms in each industry m, and the number of host firms in each industry M.

• Let f = m/M denote the ratio of source firms to host firms in each industry and r = k/K denote the ratio of skilled labor in the source relative to the host.


• Assume f > r (label the countries accordingly).• The extent of FDI increases with the number of

source firms relative to host firms.• The greater source labor demand due to the

increased number of source firms puts upward pressure on the source wage, which encourages source firms to engage in more FDI.

• Since part of the increase in labor demand is shifted abroad through FDI, host wages increase. Thus source wages as well as host wages increase with the relative number of source firms.


• The extent of FDI increases with the number of source firms relative to host firms.

• The greater source labor demand due to the increased number of source firms puts upward pressure on the source wage, which encourages source firms to engage in more FDI.

• Since part of the increase in labor demand is shifted abroad through FDI, host wages increase.

• Thus source wages as well as host wages increase with the relative number of source firms.


Proposition 1• An increase in the number of source relative to host

firms increases both the source and the host wage, decreases both source and host output of each firm, and increases the extent of FDI.

• An increase in source relative to host skilled labor supply decreases both the source and the host wage, increases both source and host output of each firm, and decreases the extent of FDI.


FDI subsidies• A subsidy to FDI directly increases the incentive for

source firms to shift production to the host country.• This production shifting transfers labor demand

from the source to the host thereby raising host wages and lowering source wages.

• This movement of wages implies that the source firms enjoy a lower cost of production relative to host firms and therefore gain market share and enjoy higher profits.


Proposition 2• A subsidy to FDI leads to a greater extent of

FDI, a lower source wage, a higher host wage, larger output by each source firm and smaller output by each host firm.

• So FDI subsidies help host workers at the expense of host firms.

• Goes on to determine the optimal FDI subsidy as a function of the parameters of the model.

Glass & Saggi SJE 2002

• Glass, Amy J. & K. Saggi (2002), “Multinational Firms and Technology Transfer,” Scandinavian Journal of Economics 104(4): 495-513.– Oligopoly model in which a multinational firm has a superior

technology compared to local firms. – Workers employed by the multinational acquire knowledge of its

superior technology. – The multinational may pay a wage premium to prevent local firms

from hiring its workers and thus gaining access to their knowledge. – The host government has an incentive to attract FDI due to

technology transfer to local firms or the wage premium earned byemployees of the multinational firm.

– However, when FDI is particularly attractive to the source firm, the host government has an incentive to discourage FDI.


Motivation• Reversal of Attitudes: Bilateral investment treaties have been

spreading like wildfire. – Most take the form of reducing constraints on foreign direct

investment (FDI). – Some even create incentives for FDI.

• Importance of FDI: Foreign affiliates now account for at least 9% of GDP in developing countries. – The gross product of such affiliates world-wide have been growing

rapidly.• Technology Transfer: Global payments of fees and royalties

for technology transfer have been escalating. – Almost all of these payments were within-the-firm rather than

between firms, so FDI is serving as a main conduit of technologytransfer.


Questions• FDI Decision: What conditions make a host

country attractive to a potential multinational?• Technology Transfer: Why might multinational

firms choose to pay wage premiums to their workers? – Under what conditions might multinational firms

control technology diffusion to local firms? – When and why might substantial movement of

workers occur from multinational to local firms?


• FDI Policy: Do the interests of host workers follow the interests of host firms? – Do the FDI incentives facing source firms follow

the interests of host welfare? Does FDI necessarily raise host welfare?

– Do higher wages or technology transfer due to FDI assure that FDI generates host benefits?

– Can FDI inducing policies raise host welfare? If so, under what situations?


Observations• Labor Movement: less prevalent in less

developed countries. Gershenberg (1987) observes only minor labor movement from multinationals to Kenyan firms. – Bloom (1992) finds substantial technological

diffusion in South Korea when production managers left multinationals to join host firms.

– Pack (1997) notes similar findings for Taiwan.


Observations• Wage Premiums: usually larger in less developed

countries. – Aitken, Harrison and Lipsey (1996) show that in Mexico

and Venezuela, multinationals are paying higher wages than local firms - even after controlling for size, location, skill mix and capital intensity.

– Haddad and Harrison (1993) report that wages paid by multinationals exceed wages paid by local firms in Morocco, even for firms within the same industry.


Existing Literature• Ethier and Markusen (1996): considers a lump-sum

payment to keep workers from leaving the multinational en mass to start a new firm (using their knowledge of the product technology). – The parent prevents technology transfer precisely when

lack of technology transfer is in the interest of the local partner.

– Hence, policy implications do not emerge from their analysis.


Existing Literature• Taylor (1993): allows firms to disguise their product

technology to limit technology transfer through imitation. – Knowledge of the technology is embedded in the product

and can be discovered by other firms through reverse engineering.

• Salop and Scheffman (1987): captures the idea that firms may take actions to raise their rival's costs although also raising their own costs. – Rivals have no means of avoiding the cost increase, so

the costs of all firm are higher in equilibrium when such a strategy is pursued.


Overview• Technology: A source/multinational firm possessing

a superior technology can conduct FDI in the host market or produce elsewhere.

• Exposure: Workers are exposed to the superior technology when they work for the multinational.

• Labor Movement: The host firm may gain access to the multinational's superior technology by hiring workers away from the multinational firm.


Overview• Wage Premium: The multinational may choose to

pay a wage premium to keep the host firm from gaining access to its technology (or produce elsewhere).

• Equilibrium: Three different equilibria depending on parameters: producing elsewhere (E), FDI with no technology transfer (N), and FDI with technology transfer (T).


Model• Duopolistic Industry: one source firm, one host firm.• Labor Supply: The industry faces a perfectly elastic

supply of workers whose wage in other sectors equals 1.

• Informed Workers: Workers are informed if exposed to the technology of the source firm; otherwise uninformed. – Informed workers are more productive at the host firm

than uninformed workers but no more productive at the source firm (contrast with experience).


Model• Production Technology: CRS, unit labor

requirement for the source firm is 1, for the local firm is θ for informed workers and Θ for uninformed workers, where 1 < θ < Θ.

• Γ ≡ Θ/θ >1 measures potential technology transfer.

• θ > 1 measures incomplete technology transfer.


Timing• Source Wage Offer: The source firm chooses the

wage wS it offers to its workers.• Host Wage Offer: The host firm chooses the wage

wH it offers the multinational's workers.• Labor Allocation: Given the wages offered by the

two firms, the multinational's workers leave to work for the host firm if offered a higher wage there.

• Output Market: Cournot competition - firms simultaneously pick quantities qS and qH, where their cost of production depends on the regime.


Technology Transfer• Lemma 1: The host firm beats the source firm's wage if not

too high (iff wS < Γ) or wH = 1.• Host Firm Indifference: At the wage Γ for informed workers,

the host firm is indifferent between hiring informed workers at cost θΓ and hiring uninformed workers at cost Θ as θ Γ=Θ.

• Wage Premium: The source firm can curtail labor movement by offering the wage wS = Γ = Θ/θ , which is the unit labor requirement for uninformed relative to informed workers at the host firm.

• Equilibrium Costs: No technology transfer cS = Γ > 1 and cH = Θ > θ. Technology transfer cS = 1 and cH = θ.


Source Threshold• Upper Boundary: At θ = Θ, source profits the same as costs

are the same.• Lower Boundary: At θ = 1, source profits are higher with

technology transfer under appropriate conditions (Θsufficiently large).

• Source Threshold: 1 < θS < Θ such that source firm profits under technology transfer and no technology transfer are equal.

• Proposition 1: For all θ ≥ θS , the source firm offers the wage wS = Γ and the no technology transfer equilibrium occurs, whereas for all θ < θS , the source firm offers the wage wS = 1 and the technology transfer equilibrium occurs.

• Figure 1: Source Profits and Technology Transfer


Host Threshold• Host Threshold: 1 < θW < Θ such that host welfare

under technology transfer and under no technology transfer are equal.

• Proposition 2: For low θ, the host country benefits more from wage premiums but receives technology transfer. For intermediate θ, the host country benefits more from technology transfer and receives technology transfer. For high θ, the host country benefits more from technology transfer but receives wage premiums.


• Cost Elsewhere: The source firm chooses to produce elsewhere if its marginal cost there, ω, is sufficiently low.

• Proposition 3: When θ ≥ θS , the source firm produces elsewhere iff the cost elsewhere is sufficiently low ω ≤ Γ or else engages in FDI and prevents technology transfer. When θ < θS , the source firm produces elsewhere iff the cost elsewhere is sufficiently low ω ≤ Ω or else engages in FDI and allows technology transfer.

• Figure 2: Source Firm Chosen Entry Mode


Policy Analysis• Induce FDI: Under what circumstances would the host

country want to induce FDI by the source firm?• Technology Transfer: If θ < θS , induce FDI so that the host

firm enjoys technology transfer from the multinational firm.• Wage Gains: If θ > θS , induce FDI so that host workers gain

higher wages from employment with the multinational firm. Total subsidy payments required are less than the wage premium generated (Γ - ω < Γ - 1 per unit of output).

• Proposition 4: The host government has an incentive to induce FDI if FDI would not otherwise occur (when the wage elsewhere ω is low) and prevent FDI if the wage elsewhere ωis sufficiently high.

• Figure 3: Host Policy toward Foreign Direct Investment


Conclusions• Simple Model: Technology transfer due to labor movement

between firms.• Rationale for Attracting FDI: generate technology transfer to

local firms or increase wages for workers.• Bad News: The two never occur together so cannot hope for

both.• Good News: One benefit is bound to occur.• More Bad News: FDI does not always increase welfare.• More Good News: Paying a subsidy to induce FDI can

improve host welfare.

Mattoo, Olarreaga & Saggi JDE 2004

• Mattoo, Aaditya, Marcelo Olarreaga & Kamal Saggi (2004), “Mode of Foreign Entry, Technology Transfer, and FDI Policy,” Journal of Development Economics 75(1): 95-111.– Foreign direct investment (FDI) can take place through the direct entry

of foreign firms or the acquisition of existing domestic firms. – Examines the preferences of a foreign firm and a welfare-maximizing

host country government over these two modes of FDI in the presence of costly technology transfer.

– The trade-off between technology transfer and market competition emerges as a key determinant of preferences.

– The clash between the foreign firm’s equilibrium choice and the local government’s ranking of the two modes of entry can provide a rationale for some frequently observed FDI restrictions.


• In the model, the degree of technology transfer and the intensity of market competition depend upon the mode of entry chosen by the foreign firm.

• A foreign firm can choose between two modes of entry: – direct entry by establishing a new wholly owned subsidiary, or – acquisition of one of the existing domestic firms.

• The extent to which a host country benefits from transfers of modern technologies and more competitive product markets due to FDI may depend upon the mode of entry. – Sheds light on the relationships between mode of entry, technology

transfer, and market structure.


• The competition enhancing effect of FDI is greater under direct entry.

• However, one mode does not unambiguously dominate the other in terms of the extent of technology transfer.

• On the one hand, the relatively larger market share that the foreign firm enjoys under acquisition increases its incentive for transferring costly technology (scale effect).

• On the other hand, strategic incentives to transfer technology in order to wrest market share away from domestic rivals can be stronger in more competitive environments (strategic effect).


• Model is most relevant to situations where cross-border delivery is either infeasible or not the most efficient mode of supply.

• For example, in many services, ranging from construction to local telecommunications, commercial presence of foreign firms via FDI is required in the host country.

• Divergence between the foreign firm’s choice and the welfare interest of the domestic economy can create a basis for policy intervention.


• For high costs of technology transfer, domestic welfare is generally higher under acquisition relative to direct entry, whereas the foreign firm chooses direct entry. – Thus, restricting direct entry to induce acquisition

can improve welfare, even in highly concentrated markets.


• On the other hand, if the cost of technology transfer is low, then domestic welfare is higher under direct entry relative to acquisition whereas the foreign firm prefers acquisition to direct entry. – As a result, restricting the acquisition of a

domestic firm can help improve host country welfare by inducing direct entry by the foreign firm.


• For intermediate costs of technology transfer, both the government and the foreign firm prefer acquisition to direct entry.

• Thus, the objective of frequently observed restrictions on FDI may not be to limit inflows of FDI, but rather to induce foreign firms to adopt the socially preferred mode of entry in the host country.

• Restrictions on the degree of foreign ownership, even when applied symmetrically to both modes of entry (acquisition and direct entry), can induce the foreign firm to adopt the host country’s preferred mode of entry.


Literature• Some of the issues addressed here have been

studied separately before, but no analytical study of the relationship between technology transfer and mode of entry by foreign firms (as in direct entry versus acquisition).

• The literature has tended to focus on licensing and direct entry where the foreign firm seeks to prevent the dissipation of its technological advantage

• Potential motivations for international acquisition of firms include: cost reduction, risk sharing, and competition reduction.


• Lee and Shy (1992) demonstrate that restrictions on foreign ownership may adversely affect the quality of technology transferred by the foreign firm. – However, they do not allow for direct entry.

• In a duopoly model, Roy et al. (1999) identify the degree of cost asymmetry between the foreign and local firm and market structure as the crucial determinants of optimal domestic policy. – However, they assume technology transfer be costless

and do not examine the differing incentive to transfer technology under alternative market structures.


• Papers on mergers and acquisitions have shown that when firms are symmetric, a firm will always prefer direct entry to acquisition of an existing firm when there is more than one target firm in the market.– Turns out that this result does not hold in the presence of

technology transfer, as shown later in this paper.• There is a large literature is concerned with the

relationships between trade and competition policy and the international effects of purely national mergers. – None of those papers are concerned with technology

transfer.


Model• Two goods (z and y) • Good y serves as a numeraire

– perfect competition– constant returns to scale technology

• n - 1 denote domestic firms can produce good z at constant marginal cost c.


• A foreign firm has two options for entering the domestic market. – acquire a domestic firm or – set up a wholly owned subsidiary that directly

competes with domestic firms. • Under acquisition the total number of firms in

the market equals n - 1 whereas under direct entry it equals n.


• In the first stage, the foreign firm chooses its mode of entry (E denotes direct entry and A denotes acquisition).

• If it wants to acquire a domestic firm, it makes a take-it-or-leave-it offer to the target firm which specifies a fixed transaction price (v).

• If the target firm accepts the offer, they form a new firm that is owned by the foreign firm.

• If the foreign firm’s offer is refused by the domestic firm, the foreign firm can enter the market by establishing its own subsidiary or by acquiring another domestic firm.


• After selecting its mode of entry, the foreign firm chooses the quality of technology to transfer to its subsidiary. – Technology transfer lowers the marginal cost of

production but is a costly process. – By incurring the cost C(x), the foreign firm can lower the

cost of production of its subsidiary in the domestic economy to c - x.

– If transfers no technology, the marginal cost of its subsidiary equals that of the domestic firm.

• In the last stage, firms compete in a Cournot–Nash fashion.


• Strategic effect of technology transfer: an increase in x lowers the output of the domestic firms thereby increasing the foreign firm’s profits.

• Scale effect of technology transfer: the higher the output of the foreign firm, the stronger its incentive for technology transfer.

• Versus the cost of technology transfer.


• The strategic effect increases with the number of existing domestic firms only if the domestic market is not too competitive.

• By contrast, in a relatively competitive market, the presence of an extra firm in the domestic market actually decreases the strategic incentive to transfer technology. – The intuition for this is that as the market gets more competitive, the

scope for strategic interactions among firms decreases and the foreign firm’s choice regarding technology transfer has a small impact on their output levels.

• This result helps explain why may observe greater technology transfer under direct entry in environments that are not very competitive.


• Proposition 1. The foreign firm transfers less technology under acquisition than under direct entry iff [s and n small].

• Direct entry may yield more technology transfer if sand n are sufficiently small.

• The equilibrium technology transfers have reasonable properties: under both direct entry and acquisition, technology transfer diminishes with the number of firms n as well as with the cost parameter s.


• In the first stage of the game, the foreign firm chooses whether to enter through acquisition or direct entry.

• Since the foreign firm has all the bargaining power under acquisition, a target domestic firm accepts an offer that leaves it with a payoff equal to that it makes as a competitor when some other domestic firm is acquired.

• The foreign firm opts for acquisition iff it is more profitable than direct entry.


• To focus on the equilibrium mode of entry chosen by the foreign firm, restrict attention to the TT and FF curves.

• The parameter space in Fig. 1 can be divided into four regions: I, II, III, and IV. – In regions I and II, direct entry leads to more technology

transfer whereas the foreign firm prefers acquisition. – In region III, acquisition leads to more technology transfer

and is indeed preferred by the foreign firm. – Finally, in region IV, direct entry is chosen by the foreign

firm whereas acquisition leads to more technology transfer.


• Proposition 2. In the host country, consumers are better off under direct entry than under acquisition whereas a typical domestic producer is better off under acquisition.

• Thus, we have a conflict between the interests of domestic producers and consumers.

• Given this conflict, the main question is whether total domestic welfare (defined as the sum of consumer surplus and producer surplus) is higher under direct entry or acquisition.


• Proposition 3. While an asymmetric equity restriction makes acquisition less attractive to the foreign firm, a symmetric equity restriction makes direct entry less attractive.

• Equity restrictions are not the only means of inducing the foreign firm to adopt a different mode of entry.

• Fiscal and financial incentives (such as the frequently witnessed tax breaks and subsidies to FDI) can also be used to induce direct entry. – Such concessions impose budgetary costs on the

government that equity restrictions do not.


Desai, Foley & Hines JPubE 2004

• Desai, Mihir, Fritz Foley & James Hines (2004). “Foreign Direct Investment in a World of Multiple Taxes,” Journal of Public Economics 88(12): 2727-2744.

• This paper examines the impact of indirect (non-income) taxes on FDI by American multinational firms, using affiliate-level data that permit the introduction of controls for parent companies and affiliate industries.

• Indirect tax burdens significantly exceed the foreign income tax obligations of foreign affiliates of American companies.


• Estimates imply that 10% higher local indirect tax rates are associated with 7.1% lower affiliate assets, which is similar to the effect of 10% higher income tax rates.

• Affiliate output falls by 2.9% as indirect taxes rise by 10%, while higher income taxes have more modest output effects.

• High corporate income tax rates depress capital/labor ratios and profit rates of foreign affiliates, whereas high indirect tax rates do not.


• The role of non-income taxes may be particularly important for FDI, since governments of many countries (including the United States) permit multinational firms to claim foreign tax credits for corporate income taxes paid to foreign governments – but do not extend this privilege to taxes other than income taxes.

• As a result, taxes for which firms are ineligible to claim credits may well have greater impact on decision-making than do (creditable) income taxes.

• Since the foreign indirect tax obligations of American multinational firms are more than one and a half times their direct tax obligations, there is obvious scope for indirect taxes to influence their behavior.


• The first is to measure the extent to which levels of FDI and rates of indirect taxation are associated, in order to assess the potential importance of indirect taxes for FDI.

• The second purpose is to compare the effects of indirect taxes and corporate income taxes in order to refine the interpretation of existing evidence of the negative association between corporate income tax rates and levels of FDI.

• Differences in the responsiveness of FDI to income taxation and indirect taxation provide a starting point for disentanglingalternative explanations for why tax rate differences appear to have the effects that they do on FDI.


• The likely impact of indirect taxes on FDI differs from that of corporate income taxes in three important ways.

• First, indirect tax obligations are not functions of reported income and are therefore little, if at all, affected by the financing of foreign affiliates and by the prices used for intra-firm transfers. – Hence the measured effect of indirect taxes on FDI is unlikely to

reflect the use of FDI to engage in tax-motivated financing and transfer pricing.

• Second, income taxes encourage firms to reduce their capital/labor ratios (and therefore FDI), while indirect taxes do so to a much lesser degree.


• Third, American firms are ineligible to claim foreign tax credits for indirect tax payments, so they are likely to be as sensitive to indirect tax rate differences as are local firms.

• These three features of the incentives created by indirect taxes narrow the range of channels through which indirect taxes are likely to affect FDI.

• The empirical results indicate that high tax rates are associated with reduced FDI by American multinational firms, and that this association is apparent for all types of taxes, including taxes other than corporate income taxes.


• Indirect tax rates are negatively correlated with investment levels - as measured by assets - roughly to the same degree as are corporate income tax rates.

• The estimates imply that American affiliates located in countries with 10% higher indirect tax rates have 7.1% fewer assets, and those in countries with 10% higher corporate income tax rates have 6.6% fewer assets.

• These effects on investment levels are mirrored in effects on output, as 10% higher indirect tax rates are associated with 2.9% less output, and 10% higher income tax rates are associated with 1.9% less output.


• High income tax rates depress affiliate capital/labor ratios and profit rates, while high indirect tax rates have no discernable effects on these variables.

• Hence it appears that high income tax rates are associated with low levels of FDI because they impose additional costs on investments, encourage taxpayers to substitute labor for capital, and affect the returns to reallocating taxable income.

• High indirect tax rates reduce FDI only by imposing additional costs, but the magnitude of their impact is comparable to that of income taxes, reflecting, in part, the non-creditability of indirect tax payments.


• Reviews existing systems of taxing international income

• Evaluates the evidence of the impact of income taxation on FDI, and

• Considers the incentives facing American firms investing in foreign countries using multiple tax instruments.


International Tax Practice• Almost all countries tax income generated by

economic activity that takes place within their borders, usually doing so at the same rates that they tax local businesses.

• In addition, many countries, including the United States, tax the foreign incomes of their residents.

• To prevent double taxation of the foreign income of Americans, United States law permits taxpayers to claim foreign tax credits for income taxes (and related taxes) paid to foreign governments.


• The United States corporate tax rate is 35%, so an American corporation that earns $100 in a foreign country with a 10% tax rate pays taxes of – $10 to the foreign government and $25 to the United

States government, – since its United States corporate tax liability of $35 is

reduced to $25 by the foreign tax credit of $10. • Since the foreign tax credit is intended to alleviate

international double taxation, and not to reduce United States tax liabilities on profits earned within the United States, the foreign tax credit is limited to United States tax liability on foreign-source income.


• International tax rules and the tax laws of other countries have the potential to influence a wide range of corporate and individual behavior, including, most directly, the location and scope of international business activity.

• A sizable literature is devoted to measuring behavioral responses to international tax rules, finding that multinational firms invest less in high-tax countries than they do in otherwise-similar low-tax countries.


• Extensive evidence that firms arrange financial flows and intra-firm sales between parent companies and subsidiaries within controlled groups in order to reallocate taxable income from affiliates in high-tax countries to affiliates in low-tax countries.

• Indirect taxes include any type of tax other than income and payroll taxes, as the BEA survey form asks for the sum of sales, value added, and excise taxes; property taxes; and import and export duties.


• Fig. 1 depicts the ratio of indirect taxes to foreign income taxes paid by American multinational firms from 1982 to 1997.

• Throughout the sample period, indirect taxes are much larger than income taxes.

• This ratio exceeds 1.5 for every year of the sample across all industries and for affiliates in manufacturing.

• Also depicts a significant increase in the relative importance of indirect taxes from the middle of the 1980s through the middle of the 1990s.



• Fig. 2 displays the ratio of indirect taxes to income taxes across all industries by country in 1994, the most recent benchmark year for which data are available, and during which the worldwide ratio of indirect taxes to income taxes was 3.5.

• For some countries, such as the Bahamas, this ratio is very large due to the relative unimportance of income taxes.


• Several large countries that host considerable amounts of United States outbound FDI impose heavy income tax burdens but nevertheless collect indirect taxes that greatly exceed their income tax collections.

• In particular, indirect tax rates appear to be high in Europe, as nine of the 10 countries with the largest ratios are European.

• Many countries in Latin America, such as Argentina and Brazil, also have ratios of indirect to income taxes that exceed the worldwide ratio of 3.5.



• Fig. 3 shows the ratio of the indirect to income tax payments of United States affiliates by industry group.

• Indirect taxes paid exceed direct taxes paid in nine of the 12 industry groups depicted.

• Substantial variation in the incidence of indirect taxes across industries. – The relative burden of indirect taxes is largest in the

petroleum sector, where indirect taxes are more than eight times larger than income taxes.

– Indirect taxes are notably lower than income taxes in financial services and other service industries



• The empirical literature clearly portray a negative relationship between local corporate profit tax rates and FDI

• There are three ways in which high profit tax rates might reduce investment: by reducing the scale of local business activity, by reducing the capital intensity of any given level of business activity, and by encouraging the relocation of assets to facilitate the relocation of profits.


• The first effect is that high tax rates increase total costs incurred by businesses in heavily taxed industries, so will generally lead to reduced production in order to maintain the profitability of local producers.

• The net impact on FDI of this reduced scale of activity is ambiguous; if production by foreign investors entails costs that are similar to those faced by local firms, then FDI should decline in a manner similar to that of local investment.

• If, however, foreign investors produce using different factor combinations than local producers, then the factor and output price reactions to higher tax rates will affect the profitability of FDI, which in turn might rise or fall.


• The second effect of corporate profit taxes is that for any given level of output, high corporate profit taxes have a depressing effect on investment and FDI, – since the taxation of the return to capital

encourages firms to substitute away from capital inputs and toward tax-deductible inputs such as labor.


• Third, multinational firms have at their disposal financial and other means to reallocate taxable income from high-tax to low-tax countries.

• This carries investment implications, since high levels of FDI may be necessary in order to justify large profits that are reported to have been earned in low-tax locations.

• Hence a low corporate income tax rate makes a country an attractive location for FDI in part because it can then provide the means of reallocating taxable income from higher-tax jurisdictions

Chor JIE 2009

• Chor, Davin (2009), “Subsidies for FDI: Implications from a Model with Heterogeneous Firms,” Journal of International Economics 78(1): 113-125.

Glass Mimeo 2012

• Glass, A.J. (2012), “Intellectual Property Policy and International Technology” Diffusion” Mimeo Texas A&M.– How do technology spillovers affect a foreign firm’s

decision whether to produce in a host country?– How does foreign direct investment (FDI) affect the

host country? – Can stronger intellectual property (IP) protection

attract FDI?– Does the host country benefit?– Is IP protection a good way to attract FDI?

Glass Mimeo 2012

Empirical Evidence• Support for FDI generating technology

spillovers:– Haddad and Harrison (1993), Kokko (1994).

• Support for IP protection affecting FDI:– Lee and Mansfield (1996), Smith (2001),

Javoncik (2001), Nunnenkamp and Spatz (2004).

Glass Mimeo 2012

Existing Models• Technology spillovers influence FDI

decisions:– Siotis (1999), Petit and Sanna-Randaccio (2000).

• Multinational firms control technology spillovers through labor mobility by paying high wages:– Markusen (2001), Fosfuri, Motta, and Ronde

(2001), Glass and Saggi (2002).

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Model of Technology Spillovers• One source and one host firm (n host firms later).• Source firm has superior process technology.• Source firm chooses exports or FDI.• FDI lowers cost of source firm: marginal cost 1 with

FDI, Ω > 1 without.• FDI also lowers cost of host firm due to technology

spillovers: marginal cost θ with FDI, Θ > θ without.

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Spillovers & Host Firm’s Costs• Host country’s IP protection sets fraction μ of

technology that may be legally imitated. • Technology spillovers generate knowledge

flows to host firm, fraction σj.– Spillovers larger under FDI than exports σX < σF,

σX = σF/Ψ, Ψ > 1• Host firms able to absorb fraction α.

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Host Firm’s Costs• Host firm’s technology (unit labor

requirement) is weighted average of source firm’s superior technology of 1 and existing technology Γ > 1.

• Weights are ασjμ and 1 - ασjμ.θ = ασFμ + (1− ασFμ) Γ, when FDI.Θ = ασXμ + (1− ασXμ) Γ, when exports.

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Timing• Host country sets its IP protection.• Source firm chooses FDI or exports.• Spillovers and absorption occurs.• Host and source firm pick quantities (standard

asymmetric Cournot duopoly/oligopoly).• Resulting prices, profits, consumer surplus,

and welfare determined.

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Source Profits• IP protection limits degree that host rival can use

technology spillovers.• Stronger IP protection raises cost of host rival more

under FDI than exports due to greater degree of technology spillovers.

• Source profits increase with IP protection (decrease with imitation) more under FDI than exports.

μμθσσ

∂Θ∂>

∂∂→> XF

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21

Sou

rce

prof

its

0 1

Fraction legally copied

S F

S X

μ S

ExportsFDI

• Source imitation threshold μS is level of IP protection such that source profits under FDI equal source profits under exports.

• It is minimum level of IP protection required for source firm to choose FDI.

• When IP protection sufficiently strong, source firm chooses FDI (otherwise exports).

)()( SXSS

FS μπμπ =

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Proposition 1• IP protection can be used to attract FDI.• FDI occurs when imitation sufficiently low μ <

μS.

( )111

111−Γ⎟

⎠⎞

⎜⎝⎛

Ψ−

−Ω⎟⎠⎞

⎜⎝⎛ +=

ασμ

nS

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Proposition 2• The source threshold decreases with

– Larger technology gap Γ.– Larger technology spillovers under FDI relative to

exports Ψ.– Larger absorption ability α.– Larger number of host firms n.– Smaller cost reduction Ω.

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Host Profits• Recall that IP protection limits degree that

host firm can use technology spillovers.• Stronger IP protection raises cost of host firm

more under FDI than exports. • Host profits decrease with IP protection

(increase with imitation) more under FDI than exports.

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4

Hos

t pro

fits

0 1

Fraction legally copied

H F

H X

μ H

Benefit from FDIHarm

μ S

• Host imitation threshold μH is level of IP protection such that host profits under FDI equal host profits under exports.

• It is maximum level of IP protection such that host firm benefits from FDI by source firm.

• When IP protection is sufficiently weak, host firm prefers FDI (otherwise exports).

)()( HXHH

FH μπμπ =

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Proposition 3• The host country can benefit from using IP

protection to attract FDI.• The host firm benefits from FDI by the source

firm provided IP protection sufficiently weak μ > μH.

( )1112

1

−Γ⎟⎠⎞

⎜⎝⎛

Ψ−

−Ω=ασ

μH

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• Host threshold lower than source threshold.

• At source imitation threshold, FDI benefits host country: host profits and consumer surplus rise (lower price & higher quantity).

• Possible for host country to benefit by strengthening IP protection to attract FDI.

• Does host country always benefit? No.

4/SH μμ =

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Host Country IP Protection• Host profits may fall if start from weak IP

protection.• FDI adversely selected in industries with least

benefits for host.• With multiple industries, gain in one industry

can be offset by losses in other industries due to higher costs for host firms.

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Conclusions• Raising IP protection can attract FDI,

provided FDI generates larger technology spillovers than exports.

• Doing so need not benefit host country.– Handicaps local firms.– Adversely selects FDI with least benefits for host

country.– Applied equally across industries.

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• IP protection not best policy instrument for attracting FDI.

• Use targeted financial incentives.• Make country more attractive in other ways.

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