Multinational corporations, intergovernmental organizations, and academics know that high levels of corporate taxation serve as a disincentive for foreign direct investment (FDI). Companies shift resources toward countries that provide the most business-friendly climate and away from those nations more hostile to investment. New research by Nahid Anaraki finds that the level of corporate taxation is even more important than fundamental macroeconomic conditions in determining the international flow of capital.
The incentives to provide foreign direct investment, whether in the form of pure financial capital, e.g. a purchase of foreign bonds, or though moving corporate activity onto foreign shores, are many: exchange rate conditions; labor market flexibility; and the average education level of the workforce, for example. Anaraki provides econometric evidence that the corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. level is the most significant variable in determining where companies direct their FDI. Figure one displays OECD member nations’ corporate tax rates and FDI net inflows as a percentage of GDP.
Former studies have shown that both domestic and multinational corporations are highly responsive to changes in the corporate tax rate. U.S. multinational corporations have the ability to move their headquarters offshore to avoid the higher rates, thereby depriving the Treasury of revenue and moving U.S. jobs overseas. High U.S. corporate tax rates were the leading cause of the spate of corporate inversions vis-à-vis mergers that took place in 2014—take Burger King and Tim Hortons (Canada), Medtronic and Covidien (Ireland), and Endo International and Paladin Labs (Ireland) as examples—and the trend is continuing in 2015, with multiple big-name companies, such as Cyberonics and Wright Medical, attempting to acquire foreign business interests in order to avoid U.S. taxes.
It’s clear that the current corporate tax system is uncompetitive. But how do we fix it?
Anaraki’s findings provide useful information for any discussion of reforming the U.S. corporate tax code. If policymakers wish to keep financial capital from fleeing the U.S., the answer is not to enact regulations that prevent companies for moving their operations out of the country. Instead, policymakers should lower corporate rates, thereby both incentivizing companies to maintain their headquarters to the U.S. and encouraging FDI.
